EBSA (Formerly PWBA) Federal Register Notice
Proposed Amendment to Prohibited Transaction Exemption (PTE) 97-34 Involving Bear, Stearns & Co. Inc., Prudential Securities Incorporated, et al., (D-10829); Notice [08/23/2000]
[PDF Version]
Volume 65, Number 164, Page 51453-51494
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Part III
Department of Labor
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Pension and Welfare Benefits Administration
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Proposed Amendment to Prohibited Transaction Exemption (PTE) 97-34
Involving Bear, Stearns & Co. Inc., Prudential Securities Incorporated,
et al., (D-10829); Notice
[[Page 51454]]
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DEPARTMENT OF LABOR
Pension and Welfare Benefits Administration
Proposed Amendment to Prohibited Transaction Exemption (PTE) 97-
34 Involving Bear, Stearns & Co. Inc., Prudential Securities
Incorporated, et al., (D-10829)
AGENCY: Pension and Welfare Benefits Administration, Department of
Labor.
ACTION: Notice of a proposed amendment to the Underwriter
Exemptions.\1\
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\1\ The term ``Underwriter Exemptions'' refers to the following
individual Prohibited Transaction Exemptions (PTEs): PTE 89-88, 54
FR 42582 (October 17, 1989); PTE 89-89, 54 FR 42569 (October 17,
1989); PTE 89-90, 54 FR 42597 (October 17, 1989); PTE 90-22, 55 FR
20542 (May 17, 1990); PTE 90-23, 55 FR 20545 (May 17, 1990); PTE 90-
24, 55 FR 20548 (May 17, 1990); PTE 90-28, 55 FR 21456 (May 24,
1990); PTE 90-29, 55 FR 21459 (May 24, 1990); PTE 90-30, 55 FR 21461
(May 24, 1990); PTE 90-31, 55 FR 23144 (June 6, 1990); PTE 90-32, 55
FR 23147 (June 6, 1990); PTE 90-33, 55 FR 23151 (June 6, 1990); PTE
90-36, 55 FR 25903 (June 25, 1990); PTE 90-39, 55 FR 27713 (July 5,
1990); PTE 90-59, 55 FR 36724 (September 6, 1990); PTE 90-83, 55 FR
50250 (December 5, 1990); PTE 90-84, 55 FR 50252 (December 5, 1990);
PTE 90-88, 55 FR 52899 (December 24, 1990); PTE 91-14, 55 FR 48178
(February 22, 1991); PTE 91-22, 56 FR 03277 (April 18, 1991); PTE
91-23, 56 FR 15936 (April 18, 1991); PTE 91-30, 56 FR 22452 (May 15,
1991); PTE 91-62, 56 FR 51406 (October 11, 1991); PTE 93-31, 58 FR
28620 (May 5, 1993); PTE 93-32, 58 FR 28623 (May 14, 1993); PTE 94-
29, 59 FR 14675 (March 29, 1994); PTE 94-64, 59 FR 42312 (August 17,
1994); PTE 94-70, 59 FR 50014 (September 30, 1994); PTE 94-73, 59 FR
51213 (October 7, 1994); PTE 94-84, 59 FR 65400 (December 19, 1994);
PTE 95-26, 60 FR 17586 (April 6, 1995); PTE 95-59, 60 FR 35938 (July
12, 1995); PTE 95-89, 60 FR 49011 (September 21, 1995); PTE 96-22,
61 FR 14828 (April 3, 1996); PTE 96-84, 61 FR 58234 (November 13,
1996); PTE 96-92, 61 FR 66334 (December 17, 1996); PTE 96-94, 61 FR
68787 (December 30, 1996); PTE 97-05, 62 FR 1926 (January 14, 1997);
PTE 97-28, 62 FR 28515 (May 23, 1997); PTE 97-34, 62 FR 39021 (July
21, 1997); PTE 98-08, 63 FR 8498 (February 19, 1998); PTE 99-11, 64
FR 11046 (March 8, 1999); PTE 2000-19, 65 FR 25950 (May 4, 2000);
PTE 2000-33, 65 FR 37171 (June 13, 2000); and PTE 2000-41, First
Tennessee National Corporation (August, 2000).
In addition, the Department notes that it is also proposing
individual exemptive relief for: Deutsche Bank AG, New York Branch
and Deutsche Morgan Grenfell/C.J. Lawrence Inc., Final Authorization
Number (FAN) 97-03E (December 9, 1996); Credit Lyonnais Securities
(USA) Inc., FAN 97-21E (September 10, 1997); ABN AMRO Inc., FAN 98-
08E (April 27, 1998); and Ironwood Capital Partners Ltd., FAN 99-31E
(December 20, 1999), which received the approval of the Department
to engage in transactions substantially similar to the transactions
described in the Underwriter Exemptions pursuant to PTE 96-62.
Finally, the Department notes that it is proposing relief for
Countrywide Securities Corporation (Application No. D-10863).
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SUMMARY: This document contains a notice of pendency before the
Department of Labor (the Department) of a proposed amendment to the
Underwriter Exemptions. The Underwriter Exemptions are individual
exemptions that provide relief for the origination and operation of
certain asset pool investment trusts and the acquisition, holding and
disposition of certain asset-backed pass-through certificates
representing undivided interests in those investment trusts. The
proposed amendment, if granted, would: (1) Permit, for certain
categories of transactions, the offering of ``investment grade''
mortgage-backed securities and asset-backed securities which are either
senior or subordinated; (2) permit the use of eligible interest rate
swaps (both ratings dependent and non-ratings dependent) under
circumstances described in this proposal; (3) permit the use of yield
supplement agreements which involve notional principal amounts; and (4)
make certain changes to the Underwriter Exemptions that would reflect
the Department's current interpretation of the Underwriter Exemptions.
Finally, the proposed amendment, if granted, would provide
exemptive relief for transactions involving: (1) an Issuer of mortgage-
backed securities or asset-backed securities which is a trust
(including a grantor or owner trust), REMIC, FASIT, special purpose
corporation, limited liability company or partnership and (2) mortgage-
backed securities or asset-backed securities issued which are either
debt or equity investments.
DATES: Written comments and/or requests for a public hearing should be
received by October 10, 2000.
Effective Date: If granted, the proposed amendment to the
Underwriter Exemptions would be effective for transactions occurring on
or after the date of publication of this notice in the Federal
Register, except as otherwise provided in sections I.C., II.A.(4)(b),
and III.JJ. of the proposed amendment to the Underwriter Exemptions.
ADDRESSES: All written comments and requests for a hearing (preferably
at least three copies) should be sent to: Office of Exemption
Determinations, Pension and Welfare Benefits Administration, Room N-
5649, Department of Labor, 200 Constitution Avenue, N.W., Washington,
D.C. 20210, Attn: Proposed Amendment to the Underwriter Exemptions. The
application pertaining to the amendment proposed herein and the
comments received will be available for public inspection in the Public
Documents Room of the Pension and Welfare Administration, U.S.
Department of Labor, Room N-5638, 200 Constitution Avenue, N.W.,
Washington, D.C. 20210.
FOR FURTHER INFORMATION CONTACT: Wendy McColough of the Department,
telephone (202) 219-8971. (This is not a toll-free number).
SUPPLEMENTARY INFORMATION: Notice is hereby given of the pendency
before the Department of a proposed exemption to amend PTE 97-34, 62 FR
39021 (July 21, 1997) (the 1997 Amendment). PTE 97-34 amended over
forty individual Underwriter Exemptions. The Underwriter Exemptions
provide substantially identical relief for the operation of certain
asset pool investment trusts and the acquisition and holding by plans
of certain asset-backed pass-through certificates representing
interests in those trusts. These exemptions provide relief from certain
of the restrictions of sections 406(a), 406(b) and 407(a) of the Act
and from the taxes imposed by section 4975(a) and (b) of the Code, by
reason of certain provisions of section 4975(c)(1) of the Code.
I. Introduction
The proposed amendment was requested by application dated October
22, 1999, and as restated in later submissions on behalf of Morgan
Stanley & Co. Incorporated.\2\ (the Applicant). In preparing the
application, the Applicant received input from members of The Bond
Market Association (TBMA).
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\2\ PTE 90-24, 55 FR 20548 (May 17, 1990). Morgan Stanley & Co.
Incorporated (Morgan Stanley) is an international securities firm
providing through its affiliates a wide range of financial and
securities services on a global basis to a large and diversified
group of clients and customers, including corporations, governments,
financial institutions and individuals. The businesses of Morgan
Stanley and its affiliates include securities underwriting,
distribution and trading; merger, acquisition, restructuring, real
estate, project finance and other corporate finance advisory
activities; asset management; private equity and other principal
investment activities; brokerage and research services; and the
trading of foreign exchange and commodities as well as derivatives
on a broad range of asset categories, rates and indices. Affiliates
of Morgan Stanley also provide credit and transaction services,
including the operation of the Discover/Novus (trademark symbol)
Network, a proprietary network of merchant and cash access
locations, and the issuance of proprietary general purpose credit
cards.
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The Department is proposing the amendment to this individual
exemption pursuant to section 408(a) of the Act and section 4975(c)(2)
of the Code, and in accordance with the procedures set forth in 29 CFR
Part 2570 (Subpart B) 55 FR 32836, 32847(August 10, 1990).\3\ In
addition, the Department
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is proposing to provide the same relief on its own motion pursuant to
the authority described above for many of the other Underwriter
Exemptions which have substantially similar terms and conditions.\4\
The Department notes that it is also proposing individual exemptive
relief for: Deutsche Bank AG, New York Branch and Deutsche Morgan
Grenfell/C.J. Lawrence Inc., FAN 97-03E (December 9, 1996); Credit
Lyonnais Securities (USA) Inc., FAN 97-21E (September 10, 1997); ABN
AMRO Inc., FAN 98-08E (April 27, 1998); and Ironwood Capital Partners
Ltd., FAN 99-31E (December 20, 1999), which received the approval of
the Department to engage in transactions substantially similar to the
transactions described in the Underwriter Exemptions pursuant to PTE
96-62. Finally, the Department notes that it is proposing relief for
Countrywide Securities Corporation (Application No. D-10863).
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\3\ Section 102 of Reorganization Plan No. 4 of 1978 (43 FR
47713, October 17, 1978, 5 U.S.C. App. 1 [1995]) generally
transferred the authority of the Secretary of the Treasury to issue
exemptions under section 4975(c)(2) of the Code to the Secretary of
Labor. In the discussion of the exemption, references to sections
406 and 408 of the Act should be read to refer as well to the
corresponding provisions of section 4975 of the Code.
\4\ In this regard, the entities who received the other
Underwriter Exemptions were contacted concerning their participation
in this amendment process.
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A. The Underwriter Exemptions
The original Underwriter Exemptions permit plans to invest in pass-
through certificates representing undivided interests in the following
categories of trusts: \5\ (1) Single and multi-family residential or
commercial mortgage investment trusts; \6\ (2) motor vehicle
receivables investment trusts; (3) consumer or commercial receivables
investment trusts; and (4) guaranteed governmental mortgage pool
certificate investment trusts.\7\ Residential and commercial mortgage
investment trusts may include mortgages on ground leases of real
property. The terms of the ground leases pledged to secure leasehold
mortgages will in all cases be at least ten years longer than the terms
of such mortgages.\8\
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\5\ The Department stated in the 1997 Proposed Amendment to the
Underwriter Exemptions, 62 FR 28502 (May 23, 1997), that a given
trust may include receivables of the type described in one or more
of the categories under the definition of Trust.
\6\ The Department noted that PTE 83-1, 48 FR 895 (January 7,
1983), a class exemption for mortgage pool investment trusts, would
generally apply to trusts containing single-family residential
mortgages, provided that the applicable conditions of PTE 83-1 are
met. The Underwriter Exemptions provide relief for single-family
residential mortgages because the applicants preferred one exemption
for all trusts of similar structure. However, the applicants have
stated that they may still avail themselves of the exemptive relief
provided by PTE 83-1.
\7\ Guaranteed governmental mortgage pool certificates are
mortgage-backed securities with respect to which interest and
principal payable is guaranteed by the Government National Mortgage
Association (GNMA), the Federal Home Loan Mortgage Corporation
(FHLMC), or the Federal National Mortgage Association (FNMA). The
Department's regulation relating to the definition of plan assets
(29 CFR 2510.3-101(i)) provides that where a plan acquires a
guaranteed governmental mortgage pool certificate, the plan's assets
include the certificate and all of its rights with respect to such
certificate under applicable law, but do not, solely by reason of
the plan's holding of such certificate, include any of the mortgages
underlying such certificate. Exemptive relief for trusts containing
guaranteed governmental mortgage pool certificates was provided
previously because the certificates in the trusts may be plan
assets.
\8\ The Department previously noted that Trust assets may also
include obligations that are secured by leasehold interests on
residential real property. See PTE 90-32 (involving Prudential-Bache
Securities, Inc.) 55 FR 23147, at 23150 (June 6, 1990).
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Each trust is established under a pooling and servicing agreement
or an equivalent agreement among a sponsor, a servicer, and a trustee.
Prior to the closing date under the pooling and servicing agreement,
the sponsor and/or the servicer selects receivables from the classes of
assets described in section III.B.(1)(a)-(f) of the original
Underwriter Exemptions to be included in a trust, establishes the trust
and designates an independent entity as trustee for the trust.
Typically, on or prior to the closing date, the sponsor acquires legal
title to all assets selected for the trust. In some cases, legal title
to some or all of such assets continues to be held by the originator of
the receivables until the closing date. On the closing date, the
sponsor and/or the originator conveys to the trust legal title to the
assets, and the trustee issued certificates representing fractional
undivided interests in the trust assets.
Since the receivables to be held in the trust were all transferred
as of the Closing Date, no exemptive relief was requested under the
Underwriter Exemptions for the trust to hold any cash, or temporary
investments made therewith, other than cash representing undistributed
proceeds from payments of principal and interest by obligors under the
receivables. However, over time, the transactions relating to the
funding of the trust changed. The 1997 Amendment to the Underwriter
Exemptions: (1) Modified the definition of ``Trust'' to include a
``pre-funding account'' (PFA) and a ``capitalized interest account''
(CIA) as part of the corpus of the trust; (2) provided retroactive
relief for transactions involving asset pool investment trusts
containing PFAs which have occurred on or after January 1, 1992; (3)
included in the definition of ``Certificate'' a debt instrument that
represents an interest in a Financial Asset Securitization Investment
Trust (FASIT); and (4) made certain changes to the Underwriter
Exemptions that reflected the Department's current interpretation of
the Underwriter Exemptions.
Under the Underwriter Exemptions as amended in 1997: (1) The rights
and interests evidenced by certificates acquired by plans may not be
subordinated to the rights and interests evidenced by other
certificates of the same trust; (2) the certificates acquired by the
plan must have received a rating from a Rating Agency at the time of
such acquisition that is in one of the three highest generic rating
categories; (3) the assets held by the trust must consist solely of
receivables, obligations or credit instruments which are ``secured,''
(4) no interest rate swaps and no yield supplement agreements or
similar yield maintenance agreements involving swap agreements or other
notional principal contracts may be held by the trust and (5) the
certificates must represent a beneficial ownership interest in the
assets of a trust or a debt instrument issued by a REMIC or a FASIT
which is a trust.
B. Proposed Amendment to the Exemptions
The proposed amendment to the Underwriter Exemptions (the Proposed
Amendment) is requested in order to permit plans to invest in
investment-grade \9\ mortgage-backed securities (MBS) and asset-backed
securities (ABS) (collectively, Securities) involving categories of
transactions which are either senior or subordinated, and/or in certain
cases, permit the entity issuing such Securities (Issuer) to hold
receivables with loan-to-value property ratios (HLTV ratios) in excess
of 100%. Specifically, the requested amendment would exempt
transactions involving senior or subordinated Securities rated ``AAA,''
``AA,'' ``A'' or ``BBB'' issued by Issuers whose assets are comprised
of the following categories of receivables: (1) Automobile and other
motor vehicle loans, (2) residential and home equity loans which may
have HLTV ratios in excess of 100%, (3) manufactured housing loans and
(4) commercial
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mortgages (the Designated Transactions).
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\9\ The term ``investment grade'' refers to Securities which are
rated at the time of issuance in one of the four highest generic
rating categories by at least one Rating Agency. The designations
``AAA,'' ``AA,'' ``A'' and ``BBB'' are used herein to refer to the
generic rating categories used by Standard & Poor's Ratings
Services, a division of The McGraw-Hill Companies Inc., Fitch ICBA,
Inc., and Duff & Phelps Credit Rating Co. and are deemed to include
the equivalent generic category rating designations ``Aaa'' ``Aa,''
``A'' and ``Baa'' used by Moody's Investors Service, Inc.
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The Applicant requests that the relief the Department granted to
MBNA America Bank National Association (MBNA) in Prohibited Transaction
Exemption 98-13, 63 FR 4038 (April 7, 1998) (PTE 98-13) and to Citibank
South Dakota, N.A., Citibank (Nevada), N.A. and affiliates (Citibank)
in Prohibited Transaction Exemption 98-14, 63 FR 4052 (April 7, 1998)
(PTE 98-14) with respect to the use of Eligible Swaps (both Ratings
Dependent and Non-Ratings Dependent) be extended to all securitizations
which otherwise meet the conditions of the Underwriter Exemptions,
provided that the swap transaction meets the requirements set forth in
the requested amendment. As a corollary to such request, the Applicant
also requests that yield supplement agreements which involve notional
principal amounts be permitted.
Finally, the Applicant is requesting that exemptive relief also be
extended to all securitization transactions which otherwise meet the
conditions of the Underwriter Exemptions notwithstanding that: (1) The
Issuer of the Securities is a trust (including a grantor or owner
trust), REMIC, FASIT, special purpose corporation, limited liability
company or partnership or that (2) the Securities issued are either
debt or equity investments.\10\
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\10\ The Department notes that this exemption request will not
preclude the Applicant (or any other parties which have previously,
or may in the future, request an Underwriter Exemption) from
requesting additional exemptive relief from the Department in future
applications with respect to other issues relating to the
Underwriter Exemptions.
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The proposed amendment to the Underwriter Exemptions specifically
will modify the relief previously provided in the following respects:
(i) The rights and interests evidenced by securities acquired by
plans in the Designated Transactions (i.e., motor vehicle,
residential/home equity, manufactured housing and commercial
mortgage ABS/MBS transactions) described in this application may be
subordinated to the rights and interests evidenced by other
securities of the same Issuer.
(ii) Securities acquired by a plan in a Designated Transaction
may receive a rating from a Rating Agency at the time of such
acquisition that is in one of the four highest generic rating
categories.
(iii) The corpus of the Issuer in residential and home equity
Designated Transactions may include mortgage loans with HLTV ratios
in excess of 100%.
(iv) Eligible interest rate swaps (both ratings dependent and
non-ratings dependent) and yield supplement arrangements with
notional principal amounts may be included.
(v) The securitization vehicle can also be an owner trust,
special purpose corporation, limited partnership or limited
liability company.
(vi) The security may be either an equity or debt interest
issued by any permissible type of Issuer.
The Applicant represents that the transactions associated with
subordinated and/or ``BBB'' rated debt and equity ABS/MBS, issued by a
variety of special purpose vehicles which may be funded with collateral
with HLTV ratios in excess of 100% and may use interest rate swaps or
yield supplement agreements with notional principal amounts, have been
customary in the financial marketplace for many years, and all of these
features and security types are taken into consideration by the Rating
Agencies when they rate the securities issued by such entities. If
these securities can not be sold to plans, investing plans will lose an
opportunity to achieve a current market return through investment in
securities that have received a rating from a Rating Agency which is as
high or higher than that of comparable instruments in which such plans
are clearly permitted to invest. In addition, thesetransactions are
backed by diverse varieties of individual assets that a plan would be
reluctant to purchase on its own, if for no other reason than the
necessity to perform its own asset-by-asset credit analysis and
servicing functions.
The Applicant notes that the requested relief is administratively
feasible since it substantially incorporates the provisions of the
Underwriter Exemptions which have already proven in practice to be
administratively feasible. To the extent that the requested amendment
permits additional types of securitization vehicles and the use of
yield supplement arrangements with notional principal balances and
interest rate swaps, the additional safeguards the Department has
required can be accommodated by market practices and do not require any
further action by the Department. The Applicant states that all of the
features included in the amendment request are also acceptable to the
Rating Agencies. The Applicant believes that the amendment is in the
interest of plan participants and beneficiaries because it provides
greater opportunities for plans to invest in a more diverse range of
liquid, extremely creditworthy securities. Lastly, the Applicant notes
that the requested amendment is protective of the rights of
participants and beneficiaries of affected plans because securities
with the features proposed in the request for amended relief have
experienced almost no defaults in their entire market history.
II. Request for Additional Types of Issuers
A. The Applicant's Request
The Applicant is requesting that the Underwriter Exemptions be
amended to expand the permissible types of securitization vehicles that
may be used to offer securities to include special purpose
corporations, limited partnerships and limited liability companies and
owner trusts, in addition to grantor trusts, REMICs and FASITs. It is
also requesting that the securities eligible for relief include those
issued by all such entities whether they are debt or equity.
When the original Underwriter Exemptions were granted, relief was
only requested for ABS/MBS issued by grantor trusts and REMICs since,
at that time, these were the principal securitization vehicles used for
asset-backed transactions. FASITs were included under PTE 97-34 in
response to legislation that had been enacted during the time period
when the relief requested under PTE 97-34 was being considered by the
Department. Currently, ABS/MBS securitizations are structured with a
variety of types of special purpose vehicles which issue both debt and
equity securities. The permissible types of Issuers used to offer
Securities include trusts (including grantor and owner trusts), special
purpose corporations, limited partnerships and limited liability
companies and may also be REMICs or FASITs. The Applicant asserts that
each of these different types of securitization entities provides
virtually the same legal protections to investors. At the request of
the Department, the Applicant provided the following discussion that
describes the legal structure, bankruptcy status and taxation of each
securitization vehicle. It also explains why debt is issued in certain
transactions instead of equity and the relative rights of both types of
securities.
The principal factors in the choice of securitization vehicle and
whether equity or debt securities are issued by the securitization
vehicle are not economic but involve a combination of tax, accounting
and ERISA considerations. In this regard, the Applicant notes that
where the Issuer is not a Trust, equity will not be sold to plans
pursuant to this exemption, if granted. In the final analysis, the
choice of securitization entity or type of security does not
significantly affect plan investors either from a legal rights,
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credit risk or tax perspective, but it significantly affects ERISA
eligibility. Accordingly, transactions are restructured solely because
of ERISA considerations which have no relationship to the safety of the
securities for plan investors.
Securitizations transactions are structured with a variety of types
of Issuers which are special purpose vehicles which issue both debt
\11\ and equity Securities. Each of the different types of
securitization entities provides virtually the same legal protections
to investors.
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\ 11\ The Department notes that PTE 84-14, 49 FR 9494 (March 13,
1984) (as corrected at 50 FR 41430 (Oct. 10, 1985), relating to
transactions determined by independent qualified professional asset
managers; PTE 90-1, 55 FR 2891 (Jan. 29, 1990), relating to certain
transactions involving insurance company pooled separate accounts;
PTE 91-38, 56 FR 31966 (July 12, 1991) (as corrected at 56 FR 59299
(Nov. 25, 1991), relating to certain transactions involving bank
collective trust funds; PTE 95-60, 60 FR 35925 (July 12, 1995),
relating to certain transactions involving insurance company general
accounts and PTE 96-23, 61 FR 15975 (Apr. 10, 1996), relating to
transactions determined by in-house asset managers collectively
(Investor-Based Exemptions), may apply to the acquisition or
disposition of debt securities by plans. The Applicant requests
relief for transactions meeting the conditions of the Underwriter
Exemptions because it would prefer one Exemption for all Issuers of
similar structures. However, the Applicant has stated that Issuers
may still issue debt securities pursuant to the Investor-Based
Exemptions.
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B. Legal Protections and Structure of Issuers
A goal in every structured finance transaction is to remove the
assets being securitized from the estate of the Sponsor so that in the
event of a bankruptcy or insolvency of such Sponsor, its creditors (or
regulators in the case of entities such as banks that are not eligible
to be debtors under the Bankruptcy Code (11 U.S.C.)) will be unable to
claim those assets or delay payments therefrom. This allows potential
buyers of Securities to base their purchasing decisions solely on the
creditworthiness of the assets and not the Sponsor. This transfer of
assets is referred to as a ``true sale.''
The Applicant asserts that if the transfer of assets by the Sponsor
is not treated as a ``true sale,'' the transaction would be deemed a
borrowing by the Sponsor, with the assets serving as collateral for the
financing. In a typical financing transaction, if the Sponsor were to
become the subject of a proceeding under the Bankruptcy Code (or
comparable regulatory provisions for entities that are not eligible to
be debtors under the Bankruptcy Code), the assets may be deemed
property of the Sponsor's estate. Although a secured creditor should
eventually realize the benefits of its pledged collateral, several
provisions of the Bankruptcy Code or comparable regulatory provisions
may operate to delay payments, and such creditor may in some cases
receive less than the full value of the pledged collateral. First,
immediately upon filing of a bankruptcy petition, Section 362(a) of the
Bankruptcy Code imposes an automatic stay on the ability of all secured
creditors to exercise their rights against pledged collateral. Other
sections of the Bankruptcy Code allow a bankruptcy court to permit the
use of pledged collateral to aid in the debtor's reorganization
(Section 363), to provide ``super priority'' liens on such assets
(Section 364), or to require a secured creditor in possession of the
collateral to return it to the debtor (Section 542). Thus, in a loan
financing transaction, the creditworthiness of the Sponsor is a prime
factor in determining whether to extend credit, as well as the value of
the collateral.
Accordingly, the goal in a structured finance transaction is to
insulate the collateral from the Sponsor. The usual mechanism to
accomplish this goal is through the creation and use of a bankruptcy
remote Issuer which issues the Securities. The assets to be securitized
are transferred to the Issuer in a ``true sale'' transaction. The
Issuer either issues Securities backed by those assets or transfers the
Securities (in a second transaction) to a second Issuer, which then
issues the Securities backed by those assets. These are known as ``one-
tier'' or ``two-tier'' transactions, respectively.
An Issuer can be formed as a corporation, limited partnership,
limited liability corporation or trust. Regardless of legal structure,
many restrictions are placed on the Issuer's operations, including its
ability to file for bankruptcy protection (either voluntarily or
involuntarily). Examples of such prohibitions are severe restrictions
on the Issuer's ability to borrow money or issue debt, as well as
prohibitions on the Issuer's merging with another entity, reorganizing,
liquidating or selling assets (outside of the permitted securitization
transactions). In this regard, the Issuer can only borrow money or
issue debt in connection with the securitization.
The documents which create the Issuer (articles/certificates of
incorporation for corporations, deeds of partnership/partnership
agreements for limited partnerships, articles of organization for
limited liability corporations or deeds of trust/trust agreements for
trusts) contain restrictive clauses significantly limiting the
activities of the Issuer (usually to just activities relating to the
securitization transactions). They also provide for the election of one
or more independent directors/partners/members whose affirmative
consent is required before a voluntary bankruptcy petition can be filed
by the Issuer. Independent directors are generally individuals not
having significant interests in, or other relationships with, the
related Sponsor or any of its affiliates. The legal documentation
evidencing the securitization often contains covenants prohibiting all
parties thereto from filing an involuntary bankruptcy petition against
the Issuer or initiating any other form of insolvency proceeding. In
this way, the Issuer, Sponsor, Servicer, trustees and others are
contractually prohibited from seeking such actions against the Issuer.
Once the Issuer is formed, the Sponsor will transfer the assets to
the Issuer, typically in exchange for the cash (and possibly some
Securities) received from the securitization transaction. This
transaction will be evidenced by appropriate legal documentation. Also,
a ``true sale'' opinion from counsel is obtained for Issuers subject to
the Bankruptcy Code. For those Issuers not subject to the Bankruptcy
Code, an opinion is obtained from counsel to the effect that in the
event of insolvency or receivership of the Sponsor, the assets
transferred to the Issuer will not be part of the estate of the
Sponsor.
The Applicant explains that the above procedures are generally
perceived as effective in removing the assets from the Sponsor's
bankruptcy estate. However, if the Sponsor were to file for bankruptcy
protection, a bankruptcy court, under the provisions of Section 105 of
the Bankruptcy Code, could still gain jurisdiction over the securitized
assets if the Issuer could be ``substantively consolidated'' with the
Sponsor. Substantive consolidation permits the bankruptcy court to
treat separate but related legal entities as one and merge the assets
and liabilities of two or more entities as if they belonged to one
debtor. If a court determines that the Issuer has not acted as a
separate legal entity but merely exists as an ``alter-ego'' of another
entity, then the court may utilize the principles of ``piercing the
corporate veil'' or substantive consolidation to gain control of the
underlying assets even if a ``true sale'' of such assets from the
Issuer to the Sponsor exists.
To prevent a court from ordering a substantive consolidation, the
applicable Rating Agencies require that the organizing documents of the
Issuer
[[Page 51458]]
contain a variety of ``separateness'' covenants. These include, among
other things, requirements that the Issuer: Maintain fully separate
books and records, not commingle assets with any other entity, maintain
separate accounts, conduct business in its own name, prepare separate
financial statements, engage only in arm's-length transactions with
affiliates, pay its liabilities only from its own funds, observe all
trust, corporate or partnership formalities (as applicable), not
guarantee the debts or pledge its assets in support of another entity,
hold itself out to be a separate legal entity and maintain adequate
capital for its business operations. In certain transactions, legal
opinions are delivered to the effect that adherence to these covenants
would be sufficient to prevent a court from ordering the substantive
consolidation of the Issuer into a debtor-parent or affiliate. The
Applicant has suggested similar restrictions relating to the activities
of the Issuer and the parties to an ABS/MBS transaction that would
serve as conditions of the exemptive relief requested with respect to
non-Trust Issuers (see section II.A.(8) of the Proposed Amendment).
The Applicant states that whether an Issuer is structured as a
corporation, limited partnership, limited liability corporation or
trust will have little impact on the relevant bankruptcy or insolvency
protection features. They are merely different legal entities with
differing structures but will produce, in the aggregate, similar types
of protections for investors. A corporation will have shareholders (who
benefit from limited liability protections) and debt holders (who enjoy
a superior claim on assets to that of shareholders and are taxed
differently). A limited partnership will have general partners (who
operate the entity and are ultimately responsible for its debts) and
limited partners (who will receive investment earnings but are only
liable to the extent of their actual investment in the event of
losses). In a limited liability corporation, ``members'' (also the
holders of equity Securities) are given the limited liability
protections of a corporation's equity holders (much like limited
partners but with a greater degree of permitted active management
abilities). In an owner trust (which is also referred to as a business
trust), the trust itself is a separately existing entity that is under
the day-to-day control of its trustee but whose profits are
distributable to the beneficial owners. According to the Applicant, an
owner trust is essentially a Delaware business trust or similar entity
as organized under other local law. An owner trust may also issue debt
instruments. It can also declare bankruptcy (unlike a common law trust
which does not exist as a legal entity distinct and separate from its
creator). As previously indicated, the specific entity chosen for a
structured finance transaction is often motivated by tax considerations
and less so by any legal advantage of one structural form over another.
C. Rights of Equity and Debt Holders
Equity holders have an undivided beneficial ownership interest in
the issuer's assets. Debt holders do not beneficially own such assets
but have a security interest in such assets which has preference over
the rights of the equity holders to such collateral. The Applicant
believes that, since the Underwriter Exemptions currently allow equity
investments by plans, it is entirely appropriate for the Department to
also provide relief for debt instruments which give their holders
preferential rights to the collateral.
The equity holders, limited partners or other beneficial owners of
all types of Issuers are liable on the obligations of the entity only
to the extent of such holders' investment and are not personally liable
on any obligations in excess thereof. In general, each type of Issuer
may issue debt, and while debt holders (or note holders) of any of
these entities do not own an ownership interest in the assets of the
Issuer, they are entitled to preferential treatment over equity holders
(e.g., certificateholders) or limited partners with respect to rights
to collateral. To protect equity and debt holders further, the pooled
assets of any specific transaction will be placed under the control of
a trustee who is independent from the Sponsor and the Servicers. This
can be accomplished in different ways depending on the type of Issuer.
If the Issuer is a trust and only equity Securities are issued, then
the trustee of the trust would have control over the pooled assets. If
instead, debt Securities are issued by any type of Issuer (trust or
non-trust), then the Indenture Trustee would have control of the pooled
assets. Accordingly, any requirements under the Proposed Exemption
applying to the ``trustee'' will apply to both the trustee of any
Issuer which is a trust and to any Indenture Trustee (each a
``Trustee'' and any Issuer which is a trust, a ``Trust''). In any
transaction where debt Securities are issued, possession of the assets
by the Trustee or filing a security interest would serve to perfect the
debt holders' security interest in the pooled assets. In transactions
involving debt Securities, the Rating Agencies require perfected
security interest opinions. The Applicant agrees to make perfected
security interest opinions a condition of exemptive relief for those
securities issued which are debt instruments.
D. Choice of Issuer and Choice of Debt Versus Equity Securities
The principal determining factors for the choice of securitization
vehicle and whether equity or debt Securities are issued are tax and
accounting considerations which have no affect on plan investors as
they are tax exempt.\12\
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\12\ Although plans are subject to tax on their unrelated
business taxable income under sections 511-514 of the Internal
Revenue Code of 1986, as amended (UBTI), the kind of income produced
in securitization transactions does not generally trigger UBTI if
the plan investor holds a Security which is treated as a debt
instrument for tax purposes.
---------------------------------------------------------------------------
Although the decision as to whether debt or equity Securities are
issued does not significantly affect the interests of the
securityholders, it does affect the Sponsor of an Issuer. A Sponsor may
want to be able to recognize the gain from the sale of the receivables
to the Issuer for accounting purposes but not have the sale trigger
gain for tax purposes. Under Statement of Financial Accounting
Standards No. 125 (FASB 125) issued by the Financial Accounting
Standards Board, generally a transfer of assets to an Issuer which
results in the Sponsor surrendering control of the transferred assets
will allow the Sponsor to book the gain for accounting purposes.
However, the tax treatment to a Sponsor can be greatly affected by
whether the Issuer issues debt or equity Securities. For example, if an
Issuer other than a REMIC or a FASIT issues debt, the Sponsor is
generally not taxed on the sale of the assets into the Trust (which is
treated instead as a financing) but will be taxed on the same
percentage of the economic gain on such sale as the proportion of
equity interest in the Issuer which is sold by the Sponsor. By way of
illustration, if an Issuer issues $100 of Securities, $6 of which are
equity and $94 are debt, and the Sponsor keeps 100% of the equity and
sells all of the debt, it will not be taxed on the gain from selling
the assets to the Trust. However, if the Sponsor issues $100 of equity
Securities and sells 94% of them, it will recognize gain of $94 on the
sale of the Securities. Accordingly, if a transaction does not qualify
under the REMIC or FASIT rules, the transaction may be structured to
issue debt instruments.
E. Effect of Tax Rules on Choice of Issuer and Securities
The Applicant notes that the choice of Issuer and whether the
Securities
[[Page 51459]]
offered are debt or equity is also greatly affected by the tax rules
governing each type of Issuer. The tax characterization of Issuers is
not necessarily the same as their characterization under local law. For
example, a Trust can be taxed as a trust, a partnership, a corporation
or be completely ignored for tax purposes. Conversely, any form of
Issuer can be treated as a REMIC or FASIT for tax purposes if it meets
the applicable requirements and so elects. However, regardless of the
tax characterizations, the transaction will be structured to avoid
double taxation; i.e., taxation at both the Issuer level and the
investor level (for investors who are tax-paying entities). The tax
treatment of each type of Issuer with respect to which exemptive relief
is requested is as follows.
1. Grantor Trust
Under the Federal tax rules which govern grantor trusts as set
forth in Treas. Reg. section 301.7701-4(c), a grantor Trust is
disregarded for tax purposes and the securityholders are generally
taxed on their ratable share of the income of the Trust. There is no
specific prohibition on a grantor Trust's ability to issue debt under
the tax rules. However, this is usually not done because if the debt
securities were ever recharacterized as equity for tax purposes, the
trust could be viewed as violating Treas. Reg. section 301.7701-4(c)
which generally prohibits multiple classes of equity from being issued.
Although a grantor Trust is not permitted to issue multiple classes of
equity with disproportionate payments or fast-pay/slow-pay structures,
it may issue a senior class and a subordinated class, provided that
they each receive normal distributions pro rata. Because a grantor
Trust may not issue Securities with different maturity dates, real
estate related securitization transactions which are intended to have
these features are often structured as REMICs.
2. REMICs
REMICs can be formed as any type of Issuer; i.e., Trust,
corporation, partnership, limited liability company or even a
segregated pool of assets. A REMIC is permitted to issue both equity
and debt Securities but usually is set up as a Trust which issues
equity Securities. The REMIC itself does not pay tax, but the residual
equity holder instead is taxed on the REMIC's taxable income. REMIC
``regular'' interests are treated as debt instruments for tax purposes.
One of the principal advantages to using a REMIC structure is that the
transaction can use a fast-pay/slow-pay structure.
3. FASITs
FASITs can also be formed as any type of Issuer and can be a
segregated pool of assets. FASITs are a type of statutory entity
created by the Small Business Job Protection Act of 1996 (SBA) through
amendments to the Code effective on September 1, 1997.\13\ FASITs are
designed to facilitate the securitization \14\ of debt obligations,
such as credit card receivables, home equity loans and auto loans, and
thus allows certain features such as revolving pools of assets, Issuers
containing unsecured receivables and certain hedging types of
investments. A FASIT is permitted to issue both equity and debt
Securities. A FASIT is not a taxable entity and debt instruments issued
by such Issuers, which might otherwise be recharacterized as equity,
will be treated as debt in the hands of the holder for tax purposes.
The holder of the ownership interest (which may not be a pension plan)
is taxed on the FASIT income. FASIT ``regular interests'' are treated
as debt instruments.
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\13\ Section 1621 of the SBA added sections 860H, 860I, 860J,
860K and 860L to the Internal Revenue Code of 1986, as amended.
\14\ Securitization is the process of converting one type of
asset into another and generally involves the use of an entity
separate from the underlying assets. In the case of securitization
of debt instruments, the instruments created in the securitization
typically have different maturities and characteristics than the
debt instruments that are securitized.
---------------------------------------------------------------------------
Although FASITs are permitted to have revolving pools of permitted
assets, exemptive relief is only currently available for FASITs that
are, in fact, passive in nature which would preclude (in the absence of
other exemptive relief) revolving asset pools. Thus, only FASITs with
assets which were comprised of secured debt and which did not allow
revolving pools of assets or hedging investments not otherwise
specifically authorized by the Underwriter Exemptions would be
permissible.
4. Owner Trusts
There are many situations where a securitization transaction wishes
to use a Trust as the Issuer but cannot qualify as a REMIC or a grantor
Trust. These include transactions that do not qualify as REMICs because
they either do not involve real estate assets (e.g., motor vehicle
transactions) or are real estate transactions where the REMIC rules are
not satisfied (e.g., the LTV ratios exceed the REMIC limits or the Pre-
Funding Period exceeds three months). If the parties wish to use the
type of tranching which uses a fast-pay/slow-pay structure, they also
cannot qualify as a grantor Trust. In such cases, the Issuer will be
set up as an owner Trust which is a business Trust. State statutory and
common law governs the formation and operation of owner trusts. An
owner Trust with more than one equity holder is treated as a
partnership with the same tax effects as the other types of Issuers
described above. The ``partnership'' is not taxed; its income is taxed
to its equity holders and any debt holders are taxed on the interest
income they receive. If the owner Trust is wholly owned, it is
disregarded for tax purposes.\15\ Whoever holds the equity in the owner
Trust is the beneficial owner of the trust assets. Therefore, if the
equity is sold to more than one entity it could have multiple
beneficial owners. The debt holder(s) would have a security interest in
the owner Trust assets.
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\15\ Whether an entity is wholly owned or owned by more than one
equity holder is determined under the tax rules.
---------------------------------------------------------------------------
5. Limited Liability Companies, Partnerships and Special Purpose
Corporations
Entities which are limited liability companies with more than one
equity holder or are partnerships under local law are taxed as
partnerships. If the limited liability company is wholly owned, it is
also disregarded for tax purposes.\16\ A special purpose corporation is
taxed on its income, but it receives a deduction for interest paid to
debt holders, so the tax result is similar to that of a partnership.
---------------------------------------------------------------------------
\16\ Id.
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While the permissible types of Issuers under the requested
exemption include Issuers which are not required under the tax rules to
be passive entities,\17\ in order for a transaction to qualify for
exemptive relief, each of the applicable requirements of the
Underwriter Exemptions as modified must be met. This would mean, for
example, that only transactions involving Issuers holding assets which
are comprised of secured debt (unless the assets are residential and
home equity loans in a Designated Transaction) and which do not allow
revolving pools of assets or hedging investments (unless specifically
authorized) are permissible under the requested relief. Specifically,
the Issuer must be maintained as an essentially passive entity, and,
therefore, both the Sponsor's discretion and the Servicer's discretion
with respect to assets included in an Issuer must be severely limited
both as to those assets transferred on the Closing Date and
[[Page 51460]]
those acquired during any Pre-Funding Period. Pooling and Servicing
Agreements provide for the substitution of Issuer receivables by the
Sponsor only in the event of breaches of representations and warranties
or defects in documentation discovered within a short time after the
issuance of Securities (within 120 days, except in the case of
obligations having an original term of 30 years, in which case the
period will not exceed two years). Any receivable so substituted is
required to have characteristics substantially similar to the replaced
receivable and will be at least as creditworthy as the replaced
receivable. In some cases, the affected receivable would be
repurchased, with the purchase price applied as a payment on the
affected receivable and passed through to securityholders.
---------------------------------------------------------------------------
\17\ Grantor trusts and REMICs are required under the tax rules
to be passive entities with limited asset substitution rights, but
other types of Issuers are not so restricted.
---------------------------------------------------------------------------
F. The Applicant's Arguments for Exemptive Relief for Different Types
of Issuers and Securities
Although, as previously noted, the choice of Issuer does not
significantly affect the rights of securityholders or the safety of the
investments, ERISA's prohibited transaction rules affect whether plan
investors can purchase these different forms of ABS/MBS. The plan asset
regulation set forth at 29 CFR Sec. 2510-3.101 (the Plan Asset
Regulation) was intended to prevent an employee benefit plan subject to
ERISA from retaining an asset manager indirectly through an equity
investment by the plan in an investment fund in order to avoid the
fiduciary responsibility and prohibited transaction provisions of
ERISA. The Department made a determination that debt instruments should
not be subject to the Plan Asset Regulations as they were not likely to
be vehicles for the indirect provision of investment management
services.\18\ As a consequence of this regulation, the treatment of
debt and the treatment of equity is very different under ERISA. Equity
investments in ABS/MBS not only can result in the purchase and sale of
the securities triggering prohibited transactions, but if the
underlying assets of the Trust are deemed to include plan assets, the
operation of the Trust and the servicing of its assets can also trigger
prohibited transactions.
---------------------------------------------------------------------------
\18\ See the preamble to the final Plan Asset Regulation, 51 FR
41280 (Nov. 13, 1986).
---------------------------------------------------------------------------
In contrast, investments in ABS/MBS which are debt securities avoid
any plan asset issues with respect to the operation of the Trust.
However, they can still result in one or more prohibited transactions.
This is because the acquisition or disposition of the debt security
itself may be a sale or exchange of property between a plan and a party
in interest and also an extension of credit between such entities. The
acquisition or disposition of the debt securities may be covered under
PTE 75-1. However, in many ABS/MBS transactions, the conditions of PTE
75-1 may not be met, i.e., where a broker-dealer is not selling the
securities but is instead acting as the placement agent for securities
which are being offered pursuant to a private placement exempt from
registration under the Securities Act of 1933. Similarly, if a plan
sold the ABS/MBS to a party in interest in the secondary market, Part V
of PTE 75-1 would not apply since it is limited to extensions of credit
to a plan in connection with the purchase or sale of securities (e.g.,
extensions of credits during the three-day settlement period).
When a plan purchases an ABS/MBS which is a debt security, it is
effectively viewed as an extension of credit to the Issuer for ERISA
purposes. While the Issuer, as a newly formed, special purpose entity,
would not be a party in interest with respect to such plan, if the
Issuer is deemed to be an affiliate of an existing party in interest,
this could create a prohibited extension of credit. Whenever ABS/MBS
are issued as debt, some other entity will own the equity of the
Issuer, either as a residual equity interest held by the Sponsor or all
or part of the equity could be sold to the public. If any equity holder
which owns a 50% or more interest in the Issuer is a party in interest
with respect to a plan holding the debt security, the Issuer will be
deemed a party in interest under 3(14)(G) of ERISA. This problem is
compounded by the fact that most publicly-offered securities are held
by the Depository Trust Company and Clearing Corporation so that the
identity of the public equity holders may not be known either at the
initial issuance of the securities or when a security is sold in the
secondary market. Accordingly, there is a need for the Underwriter
Exemptions to cover the acquisition, disposition and holding of debt
securities which is not met by PTE 75-1.
As debt securities generally are not eligible for relief under the
Underwriter Exemptions, an ABS/MBS which is a debt security may not be
purchased by a plan investor from a party in interest unless another
exemption is available. This is an anomalous result since the rights of
debt holders in ABS/MBS transactions are senior to those of
Certificateholders, and the decision to issue debt or equity ABS/MBS is
not dictated by the relative rights of the investor but is made based
on tax and accounting considerations which are not relevant to plan
investors. In fact, purchasers make the decision to invest in ABS/MBS
based on the projected return on the securities and the quality and
sufficiency of the underlying obligations in the pool without regard to
the characterization as debt or equity. According to the Applicant,
either type of security issued in an ABS/MBS transaction is viewed by
plan investment managers as a fixed income alternative to corporate
bonds. The fact that ABS/MBS pass-through Certificates are equity
interests under local law is completely disregarded by plan investors
except to the extent that the equity characterization negatively
impacts ERISA eligibility of those securities in the absence of an
exemption. Thus, the Applicant asserts that allowing debt securities
issued in ABS/MBS transactions to be eligible securities under the
Underwriter Exemptions is beneficial to such investors in their efforts
to diversify plan assets.
In this regard, the Applicant has submitted letters from the Rating
Agencies which state that the legal form of the issuer does not affect
the ratings given to comparable securities and that the Rating
Agencies' analysis takes into account the legal and structural risks of
each type of Issuer. Accordingly, the Applicant believes that, if a
particular transaction has sufficient substantive safeguards to protect
the interests of plan investors, the choice of Issuer or whether the
particular security is debt or equity should not be determinative of
whether they are eligible investments for ERISA plans.
Although the Applicant is requesting that the definition of
securitization vehicle be expanded to include special purpose
corporations, partnerships and limited liability companies, none of
which is a Trust, the Applicant believes that any and all requirements
under the Underwriter Exemptions which currently are applicable to the
``Trustee'' will continue to be applicable and are appropriate no
matter what type of Issuer is used. This is because, even in
transactions where the Issuer is not a Trust, ABS/MBS which are debt
securities will be issued pursuant to a Trust indenture, and there will
be an Indenture Trustee representing the interests of debt holders
which will be independent of the Sponsor and other members of the
Restricted Group. The Indenture Trustee is the trustee appointed
pursuant to an indenture which provides for the pledge of collateral to
secure the debt securities issued by the issuer pursuant to the
[[Page 51461]]
indenture and sets forth the rights of the debt holders. Accordingly,
the fact that an Issuer which is not a Trust does not have a Trustee
will not affect the existing requirement under the Underwriter
Exemptions relating to an independent Trustee that is not an affiliate
of any other member of the Restricted Group (see section III.M. of the
Proposed Amendment). Thus, there will always be an Independent Trustee
in transactions entered into pursuant to the requested exemption. The
Applicant notes that where the Issuer is not a Trust, equity will not
be sold to plans.
G. Classes of Securities
The Applicant notes that some of the Securities will be multi-class
Securities. The Applicant requests exemptive relief for two types of
multi-class Securities: ``strip'' Securities and ``fast-pay/slow-pay''
Securities. Strip Securities are a type of Security in which the stream
of interest payments on receivables is split from the flow of principal
payments and separate classes of Securities are established, each
representing rights to disproportionate payments of principal and
interest.\19\
---------------------------------------------------------------------------
\ 19\ It is the Department's understanding that where a plan
invests in REMIC ``residual'' interest Certificates to which this
Exemption applies, some of the income received by the plan as a
result of such investment may be considered unrelated business
taxable income to the plan, which is subject to income tax under the
Code. The Department emphasizes that the prudence requirement of
section 404(a)(1)(B) of the Act would require plan fiduciaries to
carefully consider this and other tax consequences prior to causing
plan assets to be invested in Certificates pursuant to this Proposed
Exemption.
---------------------------------------------------------------------------
``Fast-pay/slow-pay'' Securities involve the issuance of classes of
Securities having different stated maturities or the same maturities
with different payment schedules. Interest and/or principal payments
received on the underlying Issuer's assets are distributed first to the
class of Securities having the earliest stated maturity of principal
and/or earlier payment schedule, and only when that class of Securities
has been paid in full (or has received a specified amount) will
distributions be made with respect to the second class of Securities.
Distributions on Securities having later stated maturities will proceed
in like manner until all the securityholders have been paid in full.
The only difference between this multi-class arrangement and a single-
class arrangement is the order in which distributions are made to
securityholders. In each case, securityholders will have a beneficial
ownership interest in the underlying Issuer's assets or a security
interest in the collateral securing such assets. Except as permitted in
a Designated Transaction, the rights of a plan purchasing Securities
will not be subordinated to the rights of another securityholder in the
event of default on any of the underlying obligations. In particular,
unless the Securities are issued in a Designated Transaction, if the
amount available for distribution to securityholders is less than the
amount required to be so distributed, all senior securityholders will
share in the amount distributed on a pro rata basis.\20\
---------------------------------------------------------------------------
\ 20\ If an Issuer issues subordinated Securities, holders of
such subordinated Securities may not share in the amount distributed
on a pro rata basis. The Department notes that the Proposed
Exemption does not provide relief for plan investment in such
subordinated Securities, unless the Securities are issued in a
Designated Transaction.
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III. Requested Modifications for Interest Rate Swap Agreements
A. Interest Rate Swaps
PTE 98-13 and PTE 98-14 provide exemptive relief for
securitizations featuring revolving pools of secured and unsecured
credit card receivables held in Trusts sponsored by MBNA and Citibank,
respectively, which Trusts may also hold simple interest rate swaps as
an asset. The granting of these exemptions involved extensive
discussions between the Department and representatives of MBNA and
Citibank as to the structure and operation of credit card
securitizations, including the use of interest rate swaps, and the
approach used by the Rating Agencies in rating these types of
securities where the rating given by the Rating Agency is dependent
upon the existence of an interest rate swap agreement.
Interest rate swaps are used in non-credit card securitization
transactions in the same manner that they are used in credit card
transactions; i.e., where the index used to calculate interest payments
on the receivables is different than the index used to calculate
interest payments on the securities issued by the Trust. For example,
many securities bear interest based upon the London Interbank Offered
Rate for dollar deposits of a specified maturity (LIBOR). However, the
assets being securitized often bear interest at fixed rates or rates
based upon U.S. Treasury securities, the prime rate or other indices
that may not move in tandem with LIBOR. The swap helps assure that the
Trust will have sufficient funds to make full payments of interest on
the securities.
The Applicant states that a class of Securities in a non-credit
card securitization may have the benefit of an interest rate swap
agreement entered into between the Issuer and a bank or other financial
institution acting as a swap counterparty. Pursuant to the swap
agreement, the swap counterparty would pay a certain rate of interest
to the Issuer in return for a payment of a rate of interest by the
Issuer, from collections allocable to the relevant class of Securities,
to the swap counterparty. The Applicant represents that the credit
rating provided to a particular class of Securities by the relevant
Rating Agency may or may not be dependent upon the existence of a swap
agreement. Thus, in some instances, the terms and conditions of the
swap agreements will not affect the credit rating of the class of
Securities to which the swap relates (i.e., a Non-Ratings Dependent
Swap).
The Applicant requests that the same exemptive relief which has
been provided to MBNA and Citibank with respect to interest rate swaps
be extended to all securitization transactions, otherwise meeting the
conditions of the requested amendment. Thus, the Applicant is
requesting relief for both ratings dependent and non-ratings dependent
swaps as described in PTE 98-13 and PTE 98-14 (the Credit Card
Exemptions), subject to the same terms and conditions regarding
interest rate swaps contained in those exemptions. Consistent with the
conditions of the Credit Card Exemptions, the Applicant has included
the swap counterparty as a member of the Restricted Group. However, two
revisions regarding interest rate swaps are necessary in order to make
the swap provisions compatible with fixed asset pool transactions.
First, the Credit Card Exemptions require that a ratings dependent
swap include as an early payout event the withdrawal or reduction by a
Rating Agency of the swap counterparty's credit rating where the
Servicer has failed to meet its obligations under the Pooling and
Servicing Agreement relating to obtaining a replacement swap agreement
or causing the swap counterparty to post collateral. The early payout
causes principal to be paid out for the benefit of securityholders
instead of being used to purchase additional credit card receivables.
In contrast, all principal and interest payments received by the Issuer
in non-revolving pool transactions are used to make payments to either
the securityholders, the swap counterparty or to pay servicing fees or
other expenses; none are used to purchase additional obligations for
deposit into the Issuer. Accordingly, the concept of an early payout
event is not relevant for
[[Page 51462]]
the non-revolving pools of assets which are covered under the
Underwriter Exemptions. Instead, the Applicant is proposing that if the
swap counterparty's rating is downgraded, and the Servicer fails to
obtain an acceptable replacement swap or to cause the swap counterparty
to post collateral or make other arrangements satisfactory to the
Rating Agency, the plan certificateholders would be notified in the
immediately following Trustee's periodic report and would have sixty
days thereafter to dispose of the Certificates before the exemptive
relief under section I.C. of the Underwriter Exemptions with respect to
the servicing, management and operation of the Issuer would
prospectively cease to be available. The party responsible for such
notification may be the Sponsor, the Trustee, a third-party
administrator or any other party designated in the pooling and
servicing agreement and/or servicing agreement to give periodic reports
to the securityholders.
Second, the Credit Card Exemptions use the term ``Excess Finance
Charge Collections'' which is not relevant to non-credit card ABS/MBS
transactions. Accordingly, the Applicant has substituted the term
``Excess Spread'' which is the functionally equivalent term and best
suited to the types of transactions covered by the Underwriter
Exemptions. The term ``excess spread'' applies to both ratings
dependent and non-ratings dependent swaps and is defined as the amount,
as of any given day funds are distributed from the issuer, by which the
interest allocated to the securities exceeds the amount necessary to
pay interest to the securityholders, servicing fees and issuer
expenses. This term is defined in section III.II. of the Proposed
Amendment.
The Applicant believes that allowing the use of interest rate swaps
is beneficial to plan investors as it helps to protect them from the
risk of interest rate fluctuations. The conditions the Department has
imposed in PTE 98-13 and PTE 98-14, which will be met with respect to
any interest rate swap used in transactions covered by the requested
exemption, will further protect the interest of plans. Accordingly, the
Applicant represents that whether or not the credit rating of a
particular class of Securities is dependent upon the terms and
conditions of one or more interest rate swap agreements entered into by
the Issuer (i.e., a ``Ratings Dependent Swap'' or a ``Non-Ratings
Dependent Swap''), each particular swap transaction will be an
``Eligible Swap'' as defined in the Proposed Amendment.
B. Conditions
In this regard, an Eligible Swap will be a swap transaction:
1. Which is denominated in U.S. Dollars;
2. Pursuant to which the Issuer pays or receives, on or immediately
prior to the respective payment or distribution date for the applicable
class of Securities, a fixed rate of interest or a floating rate of
interest based on a publicly available index (e.g. LIBOR or the U.S.
Federal Reserve's Cost of Funds Index (COFI)), with the Issuer
receiving such payments on at least a quarterly basis and being
obligated to make separate payments no more frequently than the
counterparty, with all simultaneous payments being netted;
3. Which has a notional amount that does not exceed either: (i) The
principal balance of the class of Securities to which the swap relates,
or (ii) the portion of the principal balance of such class represented
solely by those types of corpus or assets of the Issuer referred to in
subsections III.B. (1), (2) and (3) of the Proposed Amendment;
4. Which is not leveraged (i.e., payments are based on the
applicable notional amount, the day count fractions, the fixed or
floating rates designated in item (b) above and the difference between
the products thereof, calculated on a one-to-one ratio and not on a
multiplier of such difference);
5. Which has a final termination date that is the earlier of the
date on which the Issuer terminates or the related class of Securities
is fully repaid; and
6. Which does not incorporate any provision which could cause a
unilateral alteration in any provision described in items (1) through
(5) above without the consent of the Trustee.
In addition, any Eligible Swap entered into by the Issuer will be
with an ``Eligible Swap Counterparty,'' which will be a bank or other
financial institution with a rating at the date of issuance of the
Securities by the Issuer which is in one of the three highest long-term
credit rating categories, or one of the two highest short-term credit
rating categories, utilized by at least one of the Rating Agencies
rating the Securities; provided that, if a swap counterparty is relying
on its short-term rating to establish its eligibility, such
counterparty must either have a long-term rating in one of the three
highest long-term rating categories or not have a long-term rating from
the applicable Rating Agency, and provided further that if the class of
Securities with which the swap is associated has a final maturity date
of more than one year from the date of issuance of the Securities, and
such swap is a Ratings Dependent Swap, the swap counterparty is
required by the terms of the swap agreement to establish any
collateralization or other arrangement satisfactory to the Rating
Agencies in the event of a ratings downgrade of the swap counterparty.
Under any termination of a swap, the Issuer will not be required to
make any termination payments to the swap counterparty (other than a
currently scheduled payment under the swap agreement) except from
Excess Spread or other amounts that would otherwise be payable to the
Servicer or the Sponsor.
With respect to a Rating Dependent Swap, the Servicer shall either
cause the Eligible Counterparty to establish certain collateralization
or other arrangements satisfactory to the Rating Agencies in the event
of a rating downgrade of such swap counterparty below a level specified
by the Rating Agency (which will be no lower than the level which would
make such counterparty an Eligible Counterparty), or the Servicer shall
obtain a replacement swap with an Eligible Swap Counterparty acceptable
to the Rating Agencies with substantially similar terms. If the
Servicer fails to do so, the plan securityholders will be notified in
the immediately following Trustee's periodic report to securityholders
and will have a 60-day period thereafter to dispose of the Securities,
at the end of which period the exemptive relief provided under section
I.C. of the Underwriter Exemption (relating to the servicing,
management and operation of the Issuer) would prospectively cease to be
available. With respect to Non-Ratings Dependent Swaps, each Rating
Agency rating the Securities must confirm, as of the date of issuance
of the Securities by the Issuer, that entering into the swap
transactions with the Eligible Counterparty will not affect the rating
of the Securities, even if such counterparty is no longer an Eligible
Counterparty and the swap is terminated.\21\
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\21\ In the course of considering applications for exemptive
relief under PTE 98-13 and PTE 98-14, the Department received
representations from the Rating Agencies that certain classes of
Securities issued by an Issuer holding receivables will have
Securities ratings that are not dependent on the existence of a swap
transaction entered into by the Issuer. Therefore, a downgrade in
the swap counterparty's credit rating would not cause a downgrade in
the rating established by the Rating Agency for the Securities.
These Rating Agency representations stated that in such instances,
there will be more credit enhancements (e.g., ``excess spread,''
letters of credit, cash collateral accounts) for the class to
protect the securityholders than there would be in a comparable
class where the Issuer enters into a so-called Ratings Dependent
Swap. Non-Ratings Dependent Swaps are generally used as a
convenience to enable the Issuer to pay certain fixed interest rates
on a class of Securities. However, the receipt of such fixed rates
by the Issuer from the counterparty is not a necessity for the
Issuer to be able to make its fixed rate payments to the
securityholders.
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[[Page 51463]]
Any class of Securities to which one or more swap agreements
entered into by the Issuer applies will be acquired or held only by
Qualified Plan Investors. Qualified Plan Investors will be plan
investors represented by an appropriate independent fiduciary that is
qualified to analyze and understand the terms and conditions of any
swap transaction relating to the class of Securities to be purchased
and the effect such swap would have upon the credit rating of the
Securities to which the swap relates.
For purposes of the Underwriter Exemptions, such a qualified
independent fiduciary will be either:
(a) A ``qualified professional asset manager'' (i.e., QPAM), as
defined under Part V(a) of PTE 84-14;
(b) An ``in-house asset manager'' (i.e., INHAM), as defined under
Part IV(a) of PTE 96-23; or
(c) A plan fiduciary with total assets under management of at least
$100 million at the time of the acquisition of such Securities.
C. Yield Supplement Agreements
A yield supplement agreement is a contract under which the issuer
makes a single cash payment to the contract provider in return for the
contract provider promising to make certain payments to the issuer in
the event of market fluctuations in interest rates. For example, if a
class of securities promises an interest rate which is the greater of
7% or LIBOR and LIBOR increases significantly, the yield supplement
agreement might obligate the contract provider pay to the issuer the
excess of LIBOR over 7%. In some circumstances, the contract provider's
obligation may be capped at a certain aggregate maximum dollar
liability under the contract. Alternatively, a cap could be placed on
the supplemental interest that would be paid to a securityholder from
monies paid under the yield supplement agreement. For example, the
yield supplement agreement would provide the difference between LIBOR
and 7% but only to the extent that the securityholder would be paid a
total of 9%. The interest to be paid by the contract provider to the
issuer under the yield supplement agreement is usually calculated based
on a notional principal balance which may mirror the principal balances
of those classes of securities to which the yield supplement agreement
relates or some other fixed amount. This notional amount will not
exceed either: (i) The principal balance of the class of Securities to
which such agreement or arrangement relates, or (ii) the portion of the
principal balance of such class represented solely by those types of
corpus or assets of the Issuer referred to in subsections III.B. (1),
(2) and (3) of the Proposed Amendment. In all cases, the issuer makes
no payments other than the fixed purchase price for the yield
supplement agreement and may, therefore, be distinguished from an
interest rate swap agreement, notwithstanding that both types of
agreements may use an ISDA form of contract. The 1997 Amendment
includes within the definition of ``Trust'' cash or investments made
therewith which are credited to an account to provide payments to
certificateholders pursuant to any yield supplement agreement or
similar yield maintenance arrangement provided that such arrangements
do not involve swap agreements or other notional principal contracts.
However, the Applicant notes that the Credit Card Exemptions (PTE 98-13
and PTE 98-14) permit interest rate swaps which clearly feature
notional principal amounts. In addition to requesting exemptive relief
for ``plain vanilla'' interest rate swaps, the Applicant also requests
relief for yield supplement arrangements that do not involve interest
rate payments by the Trustee, even if they have a notional principal
amount.
Accordingly, the Applicant is requesting that yield supplement
agreements with notional principal amounts be permitted retroactively
to April 7, 1998, which is the date that PTE 98-13 and PTE 98-14 were
issued as final exemptions. The Applicant's request for relief covers
only the type of interest rate cap agreements which are currently
covered under the Underwriter Exemptions. The only change being
requested is to clarify that agreements which have a notional principal
balance and/or are set forth on International Swaps and Derivatives
Association, Inc. (``ISDA'') forms will be permitted.
The Applicant notes that no ``plan assets'' within the meaning of
the Plan Asset Regulation (under 29 CFR 2510-3-101) are utilized in the
purchase of the cap agreement, as the Sponsor or some other third party
funds such arrangement with an up-front single-sum payment. The
Issuer's only obligation is to receive payments from the counterparty
if interest rate fluctuations require them under the terms of the
contract and to pass them through to securityholders. The Rating
Agencies examine the creditworthiness of the counterparty in a ratings
dependent yield supplement agreement. The Applicant suggests that the
relief for yield supplement agreements should be subject to the same
conditions as for interest rate swaps found in the Credit Card
Exemptions ( PTE 98-13 and PTE 98-14), to the extent relevant. These
conditions would include that the yield supplement agreement must be
denominated in U.S. dollars, the agreement must not be leveraged, any
changes in these conditions must be subject to the consent of the
Trustee, and the counterparty must be subject to the same eligibility
requirements as an interest rate swap counterparty.
IV. Other Features of Securitizations
A. Formation of the Issuer
Each Issuer is established under a Pooling and Servicing Agreement
or equivalent agreement between a Sponsor, a Servicer and a Trustee.
Prior to the Closing Date under the Pooling and Servicing Agreement,
the Sponsor and/or Servicer selects receivables from the classes of
assets described in section III.B.(1)(a)-(f) of the Underwriter
Exemptions to be included in the Issuer, establishes the Issuer and
designates an independent entity as Trustee. Typically, on or prior to
the Closing Date, the Sponsor acquires legal title to all assets
selected for the Issuer. In some cases, legal title to some or all of
such assets continue to be held by the originator until the Closing
Date. On the Closing Date, the Sponsor and/or the originator conveys to
the Issuer legal title to the assets, and the Issuer issues Securities
representing fractional undivided interests in the Issuer's assets and/
or debt obligations of the Issuer.
B. Pre-Funding Accounts
While in many cases all of the receivables to be held in the Issuer
are transferred to the Issuer on or prior to the Closing Date,\22\ it
is also common for other transactions to be structured using a Pre-
Funding Account and/or a Capitalized Interest Account as described
below. If pre-funding is used, some portion of the receivables will be
transferred after the Closing Date during an interim Pre-Funding
Period. The Pre-Funding Period for any Issuer will be
[[Page 51464]]
defined as the period beginning on the Closing Date and ending on the
earliest to occur of: (i) The date on which the amount on deposit in
the Pre-Funding Account is less than a specified dollar amount, (ii)
the date on which an event of default occurs under the related Pooling
and Servicing Agreement \23\ or (iii) the date which is the later of
three months or ninety days after the Closing Date. If pre-funding is
used, cash sufficient to purchase the receivables to be transferred
after the Closing Date will be transferred to the Issuer by the Sponsor
or originator on the Closing Date. During the Pre-Funding Period, such
cash and temporary investments, if any, made therewith will be held in
a Pre-Funding Account and used to purchase the additional receivables,
the characteristics of which will be substantially similar to the
characteristics of the receivables transferred to the Issuer on the
Closing Date. Certain specificity and monitoring requirements described
below will be met which will be disclosed in the Pooling and Servicing
Agreement and/or the prospectus \24\ or private placement memorandum.
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\22\ The Department is of the view that the term ``Issuer''
under the Underwriter Exemptions would include an Issuer: (a) The
assets of which, although all specifically identified by the Sponsor
or originator as of the Closing Date, are not all transferred to the
Issuer on the Closing Date for administrative or other reasons but
will be transferred to the Issuer shortly after the Closing Date, or
(b) with respect to which Securities are not purchased by plans
until after the end of the Pre-Funding Period at which time all
receivables are contained in the Issuer.
\23\ The minimum dollar amount is generally the dollar amount
below which it becomes too uneconomical to administer the Pre-
Funding Account. An event of default under the Pooling and Servicing
Agreement generally occurs when: (i) A breach of a covenant or a
breach of a representation and warranty concerning the Sponsor, the
Servicer or certain other parties occurs which is not cured, (ii)
there occurs a failure to make required payments to securityholders
or (iii) the Servicer becomes insolvent.
\24\ References to the term ``prospectus'' herein shall include
any related prospectus supplement thereto, pursuant to which
Securities are offered to investors.
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For a transaction involving an Issuer using pre-funding, on the
Closing Date, a portion of the offering proceeds will be allocated to
the Pre-Funding Account generally in an amount equal to the excess of:
(i) The principal amount of Securities being issued over (ii) the
principal balance of the receivables being transferred to the Issuer on
such Closing Date. In certain transactions, the aggregate principal
balance of the receivables intended to be transferred to the Issuer may
be larger than the total principal balance of the Securities being
issued. In these cases, the cash deposited in the Pre-Funding Account
will equal the excess of the principal balance of the total receivables
intended to be transferred to the Issuer over the principal balance of
the receivables being transferred on the Closing Date.
On the Closing Date, the Sponsor transfers the receivables to the
Issuer in exchange for the Securities. The Securities are then sold to
an Underwriter for cash or to the securityholders directly if the
Securities are sold through a placement agent. The cash received by the
Sponsor from the securityholders (or the Underwriter) from the sale of
the Securities issued by the Issuer in excess of the purchase price for
the receivables and certain other Issuer expenses, such as underwriting
or placement agent fees and legal and accounting fees, constitutes the
cash to be deposited in the Pre-Funding Account. Such funds are either
held in the Issuer and accounted for separately, or are held in a sub-
account or sub-trust. In either event, these funds are not part of
assets of the Sponsor.
Generally, the receivables are transferred at par value, unless the
interest rate payable on the receivables is not sufficient to service
both the interest rates to be paid on the Securities and the
transaction fees (i.e., servicing fees, Trustee fees and fees to credit
support providers). In such cases, the receivables are sold to the
Issuer at a discount, based on an objective, written, mechanical
formula which is set forth in the Pooling and Servicing Agreement and
agreed upon in advance between the Sponsor, the Rating Agency and any
credit support provider or other Insurer. The proceeds payable to the
Sponsor from the sale of the receivables transferred to the Issuer may
also be reduced to the extent they are used to pay transaction costs.
In addition, in certain cases, the Sponsor may be required by the
Rating Agencies or credit support providers to set up Issuer reserve
accounts to protect the securityholders against credit losses.
The exemptive relief provided under the 1997 Amendment for pre-
funding is limited so that the percentage or ratio of the amount
allocated to the Pre-Funding Account, as compared to the total
principal amount of the Securities being offered (the Pre-Funding
Limit), does not exceed 25% effective for transactions occurring on or
after May 23, 1997 and did not exceed 40% effective for transactions
occurring on or after January 1, 1992, but prior to May 23, 1997. The
Pre-Funding Limit (which may be expressed as a ratio or as a stated
percentage or as a combination thereof) will be specified in the
prospectus or the private placement memorandum.
Any amounts paid out of the Pre-Funding Account are used solely to
purchase receivables and to support the interest rate payable on the
Securities (as explained below). Amounts used to support the interest
rate are payable only from investment earnings and are not payable from
principal. However, in the event that, after all of the requisite
receivables have been transferred into the Issuer, any funds remain in
the Pre-Funding Account, such funds will be paid to the securityholders
as principal prepayments. Upon termination of the Issuer, if no
receivables remain in the Issuer and all amounts payable to the
securityholders have been distributed, any amounts remaining in the
Issuer would be returned to the Sponsor.
A dramatic change in interest rates on the receivables held in an
Issuer using a Pre-Funding Account would be handled as follows. If the
receivables (other than those with adjustable or variable rates) had
already been originated prior to the Closing Date, no action would be
required as the fluctuations in market interest rates would not affect
the receivables transferred to the Issuer after the Closing Date. In
contrast, if interest rates fall after the Closing Date, receivables
originated after the Closing Date will tend to be originated at lower
rates, with the possible result that the receivables will not support
the interest rate payable on the Securities. In such situations, the
Sponsor could sell the receivables into the Issuer at a discount and
more receivables will be used to fund the Issuer in order to support
the interest rate. In a situation where interest rates drop
dramatically and the Sponsor is unable to provide sufficient loans at
the requisite interest rates, the pool of receivables would be closed.
In this latter event, under the terms of the Pooling and Servicing
Agreement, the securityholders would receive a repayment of principal
from the unused cash held in the Pre-Funding Account. In transactions
where the interest rates payable on the Securities are variable or
adjustable, the effects of market interest rate fluctuations are
mitigated. In no event will fluctuations in interest rates payable on
the receivables affect the interest rate payable on fixed rate
Securities.
The cash deposited into the Issuer and allocated to the Pre-Funding
Account is invested in certain permitted investments (see below), which
may be commingled with other accounts of the Issuer. The allocation of
investment earnings to each Issuer account is made periodically as
earned in proportion to each account's allocable share of the
investment returns. As Pre-Funding Account investment earnings are
required to be used to support (to the extent authorized in the
particular transaction) the amounts of interest payable to the
securityholders with respect to a periodic distribution date, the
Trustee is necessarily required to make periodic, separate allocations
of
[[Page 51465]]
the Issuer's earnings to each Issuer account, thus ensuring that all
allocable commingled investment earnings are properly credited to the
Pre-Funding Account on a timely basis.
C. The Capitalized Interest Account
In certain transactions where a Pre-Funding Account is used, the
Sponsor and/or originator may also transfer to the Issuer additional
cash on the Closing Date, which is deposited in a Capitalized Interest
Account and used during the Pre-Funding Period to compensate the
securityholders for any shortfall between the investment earnings on
the Pre-Funding Account and the interest rate payable on the
Securities.
The Capitalized Interest Account is needed in certain transactions
since the Securities are supported by the receivables and the earnings
on the Pre-Funding Account, and it is unlikely that the investment
earnings on the Pre-Funding Account will equal the interest rates
payable on the Securities (although such investment earnings will be
available to pay interest on the Securities). The Capitalized Interest
Account funds are paid out periodically to the securityholders as
needed on distribution dates to support the interest rate. In addition,
a portion of such funds may be returned to the Sponsor from time to
time as the receivables are transferred into the Issuer and the need
for the Capitalized Interest Account diminishes. Any amounts held in
the Capitalized Interest Account generally will be returned to the
Sponsor and/or originator either at the end of the Pre-Funding Period
or periodically as receivables are transferred and the proportionate
amount of funds in the Capitalized Interest Account can be reduced.
Generally, the Capitalized Interest Account terminates no later than
the end of the Pre-Funding Period. However, there may be some cases
where the Capitalized Interest Account remains open until the first
date distributions are made to securityholders following the end of the
Pre-Funding Period.
In other transactions, a Capitalized Interest Account is not
necessary because the interest paid on the receivables exceeds the
interest payable on the Securities at the applicable interest rate and
the fees payable by the Issuer. Such excess is sufficient to make up
any shortfall resulting from the Pre-Funding Account earning less than
the interest rate payable on the Securities. In certain of these
transactions, this occurs because the aggregate principal amount of
receivables exceeds the aggregate principal amount of Securities.
D. Pre-Funding Account and Capitalized Interest Account Payments and
Investments
Pending the acquisition of additional receivables during the Pre-
Funding Period, it is expected that amounts in the Pre-Funding Account
and the Capitalized Interest Account will be invested in certain
permitted investments or will be held uninvested. Pursuant to the
Pooling and Servicing Agreement, all permitted investments must mature
prior to the date the actual funds are needed. The permitted types of
investments in the Pre-Funding Account and Capitalized Interest Account
are investments which are either: (i) Direct obligations of, or
obligations fully guaranteed as to timely payment of principal and
interest by, the United States or any agency or instrumentality
thereof, provided that such obligations are backed by the full faith
and credit of the United States or (ii) have been rated (or the Obligor
on the investment has been rated) in one of the three highest generic
rating categories by Standard & Poor's Ratings Services, a division of
The McGraw-Hill Companies Inc., (S&P's), Moody's Investors Service,
Inc. (Moody's), Duff & Phelps Credit Rating Co. (D&P), Fitch ICBA, Inc.
(Fitch) or any successors thereto (each a Rating Agency or
collectively, the Rating Agencies) as set forth in the Pooling and
Servicing Agreement and as required by the Rating Agencies. The credit
grade quality of the permitted investments is generally no lower than
that of the Securities. The types of permitted investments will be
described in the Pooling and Servicing Agreement.
The ordering of interest payments to be made from the Pre-Funding
Account and Capitalized Interest Accounts is pre-established and set
forth in the Pooling and Servicing Agreement. The only principal
payments which will be made from the Pre-Funding Account are those made
to acquire the receivables during the Pre-Funding Period and those
distributed to the securityholders in the event that the entire amount
in the Pre-Funding Account is not used to acquire receivables. The only
principal payments which will be made from the Capitalized Interest
Account are those made to securityholders if necessary to support the
Security interest rate or those made to the Sponsor either periodically
as they are no longer needed or at the end of the Pre-Funding Period
when the Capitalized Interest Account is no longer necessary.
E. The Characteristics of the Receivables Transferred During the Pre-
Funding Period
In order to ensure that there is sufficient specificity as to the
representations and warranties of the Sponsor regarding the
characteristics of the receivables to be transferred after the Closing
Date during the Pre-Funding Period:
1. All such receivables will meet the same terms and conditions for
eligibility as those of the original receivables used to create the
Issuer (as described in the prospectus or private placement memorandum
and/or Pooling and Servicing Agreement for such Securities), which
terms and conditions have been approved by a Rating Agency. However,
the terms and conditions for determining the eligibility of a
receivable may be changed if such changes receive prior approval either
by a majority vote of the outstanding securityholders or by a Rating
Agency; \25\
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\25\ In some transactions, the Insurer and/or credit support
provider may have the right to veto the inclusion of receivables,
even if such receivables otherwise satisfy the underwriting
criteria. This right usually takes the form of a requirement that
the Sponsor obtain the consent of these parties before the
receivables can be included in the Issuer. The Insurer and/or credit
support provider may, therefore, reject certain receivables or
require that the Sponsor establish certain Issuer reserve accounts
as a condition of including these receivables. Virtually all Issuers
which have Insurers or other credit support providers are structured
to give such veto rights to these parties. The percentage of Issuers
that have Insurers and/or credit support providers, and accordingly
feature such veto rights, varies.
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2. The transfer of the receivables acquired during the Pre-Funding
Period will not result in the Securities receiving a lower credit
rating from the Rating Agency upon termination of the Pre-Funding
Period than the rating that was obtained at the time of the initial
issuance of the Securities by the Issuer;
3. The weighted average annual percentage interest rate (the
average interest rate) for all of the receivables in the Issuer at the
end of the Pre-Funding Period will not be more than 100 basis points
(``bps'') lower than the average interest rate for the receivables
which were transferred to the Issuer on the Closing Date;
4. The Trustee of the Trust (or any agent with which the Trustee
contracts to provide trust services) will be a substantial financial
institution or trust company experienced in Issuer activities and
familiar with its duties, responsibilities and liabilities as a
fiduciary under the Act. The Trustee, as the legal owner of the
receivables in the Issuer or the holder of a security interest in the
receivables, will enforce all the
[[Page 51466]]
rights created in favor of securityholders of the Issuer, including
employee benefit plans subject to the Act.
In order to ensure that the characteristics of the receivables
actually acquired during the Pre-Funding Period are substantially
similar to receivables that were acquired as of the Closing Date, the
Applicant represents that for transactions occurring on or after May
23, 1997,\26\ the characteristics of the subsequently acquired
receivables will either be monitored by a credit support provider or
other insurance provider which is independent of the Sponsor or an
independent accountant retained by the Sponsor will provide the Sponsor
with a letter (with copies provided to the Rating Agencies, the
Underwriter and the Trustee) stating whether or not the characteristics
of the additional receivables acquired after the Closing Date conform
to the characteristics of the receivables described in the prospectus,
private placement memorandum and/or Pooling and Servicing Agreement. In
preparing such letter, the independent accountant will use the same
type of procedures as were applicable to the receivables which were
transferred as of the Closing Date.
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\26\ May 23, 1997, was the date the proposed 1997 Amendment to
the Underwriter Exemption was published in the Federal Register.
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Each prospectus, private placement memorandum and/or Pooling and
Servicing Agreement will set forth the terms and conditions for
eligibility of the receivables to be held by the Issuer as of the
related Closing Date, as well as those to be acquired during the Pre-
Funding Period, which terms and conditions will have been agreed to by
the Rating Agencies which are rating the applicable Securities as of
the Closing Date. Also included among these conditions is the
requirement that the Trustee be given prior notice of the receivables
to be transferred, along with such information concerning those
receivables as may be requested. Each prospectus or private placement
memorandum will describe the amount to be deposited in, and the
mechanics of, the Pre-Funding Account and will describe the Pre-Funding
Period for the Issuer.
F. Parties to Transactions
The originator of a receivable is the entity that initially lends
money to a borrower (Obligor), such as a homeowner or automobile
purchaser, or leases property to a lessee. The originator may either
retain a receivable in its portfolio or sell it to a purchaser, such as
a Sponsor.
Originators of receivables held by the Issuer will be entities that
originate receivables in the ordinary course of their business
including finance companies for whom such origination constitutes the
bulk of their operations, financial institutions for whom such
origination constitutes a substantial part of their operations, and any
kind of manufacturer, merchant, or service enterprise for whom such
origination is an incidental part of its operations. Each Issuer may
hold assets of one or more originators. The originator of the
receivables may also function as the Sponsor or Servicer.
The Sponsor will be one of three entities: (i) A special-purpose or
other corporation unaffiliated with the Servicer, (ii) a special-
purpose or other corporation affiliated with the Servicer, or (iii) the
Servicer itself. Where the Sponsor is not also the Servicer, the
Sponsor's role will generally be limited to acquiring the receivables
to be held by the Issuer, establishing the Issuer, designating the
Trustee, and assigning the receivables to the Issuer.
The Trustee of a Trust (or the Issuer, if it is not a Trust) is the
legal owner of the obligations held by the Issuer and would hold a
security interest in the collateral securing such obligations. The
Trustee is also a party to or beneficiary of all the documents and
instruments transferred to the Issuer, and as such, has both the
authority to, and the responsibility for, enforcing all the rights
created thereby in favor of securityholders, including those rights
arising in the event of default by the servicer.
The Trustee will be an independent entity, and therefore will be
unrelated to the Underwriter, the Sponsor or the Servicer or any other
member of the Restricted Group. The Applicant represents that the
Trustee will be a substantial financial institution or trust company
experienced in trust activities. The Trustee receives a fee for its
services, which will be paid by the Servicer, Sponsor or out of the
Issuer's assets. The method of compensating the Trustee will be
specified in the Pooling and Servicing Agreement and disclosed in the
prospectus or private placement memorandum relating to the offering of
the Securities.
The rights and obligations of the Indenture Trustee are no
different than those of the Trustee of an Issuer which is a Trust. The
Indenture Trustee is obligated to oversee and administer the activities
of all of the ongoing parties to the transaction and possesses the
authority to replace those entities, sue them, liquidate the collateral
and perform all necessary acts to protect the interests of the debt
holders. If debt is issued in a transaction, there may not be a pooling
and servicing agreement. Instead, there is a sales agreement and
servicing agreement (or these two agreements are sometimes combined
into a single agreement). The agreement(s) set(s) forth, among other
things, the duties and responsibilities of the parties to the
transaction relating to the administration of the Issuer. The Indenture
Trustee is often a party to these agreements. At a minimum, the
Indenture Trustee acknowledges its rights and responsibilities in these
agreements or they are contractually set forth in the indenture
agreement pursuant to which the Indenture Trustee is appointed.
The Servicer of an Issuer administers the receivables on behalf of
the securityholders. The Servicer's functions typically involve, among
other things, notifying borrowers of amounts due on receivables,
maintaining records of payments received on receivables and instituting
foreclosure or similar proceedings in the event of default. In cases
where a pool of receivables has been purchased from a number of
different originators and transferred to an Issuer, it is common for
the receivables to be ``subserviced'' by their respective originators
and for a single entity to ``master service'' the pool of receivables
on behalf of the owners of the related series of Securities. Where this
arrangement is adopted, a receivable continues to be serviced from the
perspective of the borrower by the local Subservicer, while the
investor's perspective is that the entire pool of receivables is
serviced by a single, central Master Servicer who collects payments
from the local Subservicers and pays them to securityholders.
A Servicer's default is treated in the same manner whether or not
the Issuer is a Trust. The original Servicer is replaced. The entity
replacing the Servicer varies from transaction to transaction. In
certain cases, it may be the Trustee (or Indenture Trustee if the
Issuer is not a Trust) or may be a third party satisfactory to the
Rating Agencies. In addition, there are transactions where the Trustee
or Indenture Trustee will assume the Servicer's responsibilities on a
temporary basis until the permanent replacement takes over. In all
cases, the replacement entity must be capable of satisfying all of the
duties and responsibilities of the original Servicer and must be an
entity that is satisfactory to the Rating Agencies.
As noted above, the Underwriter Exemptions currently require that
the Trustee not be an Affiliate of any
[[Page 51467]]
member of the Restricted Group. Thus, if a Servicer of receivables held
by an Issuer which has issued Securities in reliance upon the
Underwriter Exemptions (or an Affiliate thereof) merges with or is
acquired by (or acquires) the Trustee of such Trust (or an Affiliate
thereof), exemptive relief would cease to be available under the
Underwriter Exemptions. The Applicant states that, as the result of
legal constraints applicable to such merger and acquisition
transactions (e.g., confidentiality requirements), the entities
involved in the transaction are unable before the transaction is
consummated to cross check all relationships between the often numerous
Affiliates of the entities involved in the transaction in order to
determine whether or not any of the new affiliations resulting from the
transaction will violate this non-affiliation condition of the
Underwriter Exemptions. In response to this issue, the Department
proposes to revise subsection II.A.(4) of the Underwriter Exemptions to
provide that this condition will not be considered to be violated for
transactions occurring on or after January 1, 1998, merely by reason of
a Servicer becoming an Affiliate of the Trustee as the result of a
merger or acquisition between or among the Trustee, such Servicer and/
or their Affiliates which occurs after the initial issuance of the
Securities, provided that: (i) Such Servicer ceases to be an Affiliate
of the Trustee no later than six months after the later of August 23,
2000, or the date such Servicer became an Affiliate of the Trustee; and
(ii) such Servicer did not breach any of its obligations under the
Pooling and Servicing Agreement, unless such breach was immaterial and
timely cured in accordance with the terms of such agreement, during the
period from the closing date of such merger or acquisition transaction
through the date the Servicer ceased to be an Affiliate of the Trustee.
The Department proposes to make this revision retroactive to January 1,
1998 in response to the Applicant's representations that recent merger
and acquisition transactions occurring within the financial services
industry have resulted in an unknown but potentially significant number
of inadvertent violations of this condition.
The Underwriter will be a registered broker-dealer that acts as
Underwriter or placement agent with respect to the sale of Securities.
Public offerings of Securities are generally made on a firm commitment
or agency basis. Private placement of Securities may be made on a firm
commitment or agency basis. It is anticipated that the lead or co-
managing Underwriters will make a market in Securities offered to the
public.
In some cases, the originator and Servicer of receivables to be
held by an Issuer and the Sponsor of the Issuer (though they themselves
may be related) will be unrelated to the Underwriter. In other cases
however, Affiliates of the Underwriter may originate or service
receivables held by an Issuer or may sponsor an Issuer.
G. Security Price, Interest Rate and Fees
In some cases, the Sponsor will obtain the receivables from various
originators or other secondary market participants pursuant to existing
contracts with such originators or other secondary market participants
under which the Sponsor continually buys receivables. In other cases,
the Sponsor will purchase the receivables at fair market value from the
originator or a third party pursuant to a purchase and sale agreement
related to the specific offering of Securities. In other cases, the
Sponsor will originate the receivables itself.
As compensation for the receivables transferred to the Issuer, the
Sponsor receives Securities representing the entire beneficial interest
in the Issuer and/or debt Securities representing the Issuer's
obligations to debt securityholders, or the cash proceeds of the sale
of such Securities. If the Sponsor receives Securities from the Issuer,
the Sponsor sells some or all of these Securities for cash to investors
or securities underwriters.
The price of the Securities, both in the initial offering and in
the secondary market, is affected by market forces including investor
demand, the interest rate payable on the Securities in relation to the
rate payable on investments of similar types and quality, expectations
as to the effect on yield resulting from prepayment of the underlying
receivables, and expectations as to the likelihood of timely payment.
The interest rate payable on the Securities is equal to the
interest rate on receivables included in the Issuer minus a specified
servicing fee.\27\ This rate is generally determined by the same market
forces that determine the price of a Security. The price of a Security
and its interest, or coupon, rate, together determine the yield to
investors. If an investor purchases a Security at less than par, that
discount augments the stated interest rate; conversely, a Security
purchased at a premium yields less than the stated coupon.
---------------------------------------------------------------------------
\ 27\ The interest rate payable on Securities representing
interests in Issuers holding leases is determined by breaking down
lease payments into ``principal'' and ``interest'' components based
on an implicit interest rate.
---------------------------------------------------------------------------
As compensation for performing its servicing duties, the Servicer
(who may also be the Sponsor or an Affiliate thereof, and receive fees
for acting as Sponsor) will retain the difference between payments
received on the receivables held by the Issuer and payments (payable at
the interest rate) to securityholders, except that in some cases a
portion of the payments on the receivables may be paid to a third
party, such as a fee paid to a provider of credit support. The Servicer
may receive additional compensation by having the use of the amounts
paid on the receivables between the time they are received by the
Servicer and the time they are due to the Issuer (which time is set
forth in the Pooling and Servicing Agreement). The Servicer typically
will be required to pay the administrative expenses of servicing the
Issuer, including in some cases the Trustee's fee, out of its servicing
compensation.
The Servicer is also compensated to the extent it may provide
credit enhancement to the Issuer or otherwise arrange to obtain credit
support from another party. This ``credit support fee'' may be
aggregated with other servicing fees, and is either paid out of the
income received on the receivables in the Issuer in excess of the
interest rate or paid in a lump sum at the time the Issuer is
established.
The Servicer may be entitled to retain certain administrative fees
paid by a third party, usually the Obligor. These administrative fees
fall into three categories: (a) Prepayment fees; (b) late payment and
payment extension fees; and (c) expenses, fees and charges associated
with foreclosure or repossession, or other conversion of a secured
position into cash proceeds, upon default of an obligation.
Compensation payable to the Servicer will be set forth or referred
to in the Pooling and Servicing Agreement and described in reasonable
detail in the prospectus or private placement memorandum relating to
the Securities.
Payments on receivables held by the Issuer may be made by Obligors
to the Servicer at various times during the period preceding any date
on which interest payments to the Issuer are due. In some cases, the
Pooling and Servicing Agreement may permit the Servicer to place these
payments in non-interest bearing accounts in itself or to commingle
such payments with its own funds prior to the distribution dates. In
these cases, the Servicer would be entitled to the benefit derived from
the use of the funds between the date of payment on a receivable and
the
[[Page 51468]]
payment date on the Securities. Commingled payments may not be
protected from the creditors of the Servicer in the event of the
Servicer's bankruptcy or receivership. In those instances when payments
from receivables are held in non-interest bearing accounts or are
commingled with the Servicer's own funds, the Servicer is required to
deposit these payments by a date specified in the Pooling and Servicing
Agreement into an account from which the Issuer makes payments to
securityholders.
The Underwriter will receive a fee in connection with the
underwriting or private placement of Securities. In a firm commitment
underwriting, this fee would normally consist of the difference between
what the Underwriter receives for the Securities that it distributes
and what it pays the Sponsor for those Securities. In a private
placement, the fee normally takes the form of an agency commission paid
by the Sponsor. In a best efforts underwriting in which the Underwriter
would sell Securities in a public offering on an agency basis, the
Underwriter would receive an agency commission rather than a fee based
on the difference between the price at which the Securities are sold to
the public and what it pays the Sponsor. In some private placements,
the Underwriter may buy Securities as principal, in which case its
compensation would be the difference between what the Underwriter
receives for the Securities and what it pays the Sponsor for these
Securities.
H. Purchase of Receivables by the Servicer
The Applicant represents that as the principal amount of the
receivables held by an Issuer is reduced by payments, the cost of
administering the Issuer generally increases, making the servicing of
the receivables prohibitively expensive at some point. Consequently,
the Pooling and Servicing Agreement generally provides that the
Servicer may purchase the receivables remaining in the Issuer when the
aggregate unpaid balance payable on the receivables is reduced to a
specified percentage (usually between 5 and 10 percent) of the initial
aggregate unpaid balance.
The purchase price of a receivable is specified in the Pooling and
Servicing Agreement and will be at least equal to either: (1) The
unpaid principal balance on the receivable plus accrued interest, less
any unreimbursed advances of principal made by the Servicer, or (2) the
greater of the amount in (1) or (b) the fair market value of such
obligations in the case of a REMIC, or the fair market value of the
receivables in the case of an Issuer which is not a REMIC.
V. Requested Modifications for Motor Vehicles, Residential/Home
Equity, Manufactured Housing and Commercial Mortgage-Backed
Securities Transactions
A. The Applicant's Request
The Applicant requests an amendment to the 1997 Amendment to
provide relief for the offering of investment-grade mortgage-backed
securities (MBS) and asset-backed securities (ABS) which are either
senior or subordinated, and/or in certain cases, permit the Issuer to
hold receivables with loan-to-value property ratios (LTV ratios) in
excess of 100%. Specifically, this request relates to Securities issued
by Issuers for a limited number of asset categories: (1) Automobile and
other motor vehicle ABS which are senior or subordinated securities
rated ``AAA,'' ``AA,'' ``A'' or ``BBB''; (2) residential and home
equity ABS/MBS with senior or subordinated securities rated either
``AAA,'' ``AA,'' ``A'' or ``BBB,'' which are issued by Issuers whose
assets may include mortgage loans with LTV ratios in excess of 100%;
(3) manufactured housing ABS/MBS with senior or subordinated securities
rated either ``AAA,'' ``AA,'' ``A'' or ``BBB'' and (4) commercial
mortgage-backed securities (CMBS) which are senior or subordinated
securities rated ``AAA,'' ``AA,'' ``A'' or ``BBB.''
The Applicant requests that the Department include high LTV loans
as acceptable assets of the Issuer only in residential and/or home
equity transactions, as long as such loans are secured by collateral
whose fair market value on the Closing Date of the securitization
transaction is at least equal to 80% of the sum of the outstanding
principal balance due under the loan which is held as an asset of the
Issuer and that of other loans if any, of higher priority (whether or
not held by the Issuer) which are secured by the same collateral. This
modification would also address the situation where a residential or
home equity pool of assets contains a de minimis number of
undercollateralized loans. According to TBMA, a pool could have, for
example, 400 loans, 399 of which are fully secured and one of which is
99% secured, but the transaction would not qualify for the Underwriter
Exemptions. The situation cannot always be cured by removing even a
small number of loans from the pool because replacement loans may not
be available by closing, and pre-funding may not be feasible. The
Applicant has suggested as additional safeguards, that: (i) the rights
and interests evidenced by the Securities issued in such Designated
Transactions involving residential and/or home equity transactions with
high LTV loans are not subordinated to the rights and interests
evidenced by Securities of the same Issuer, and (ii) such Securities
acquired by the plan have received a rating from a Rating Agency at the
time of such acquisition that is in one of the two highest generic
rating categories.
The Applicant believes that it is appropriate for the Department to
provide relief for Designated Transactions for three principal reasons.
First, such ABS/MBS have proven to be extremely safe investments
with superior credit performance and investment return. Defaults on
investment-grade ABS/MBS have occurred in only isolated instances,
despite significant down-market cycles experienced during the financial
history of such securities. In addition, comparably rated corporate
bonds have historically experienced more downgrades and a much greater
number of defaults. Even during extreme credit market conditions, such
as those of the late summer and early fall of 1998 which put severe
cash flow stress on securitization Sponsors, ABS/MBS securitization
structures maintained their integrity and continued to perform in
accordance with their terms.
Second, allowing a broader range of ABS/MBS to be purchased by plan
investors as an alternative to corporate bonds is beneficial to plan
participants and their beneficiaries because it allows greater
diversification of investments by plans without sacrificing the safety
and credit quality of those investments. It also gives plan investors
the flexibility of being able to structure a portfolio of fixed income
securities with varying maturities and cash flow characteristics that
can be tailored to the unique requirements of each plan.
Third, most ABS/MBS, unlike corporate bonds whose performance is
dependent on the financial condition of one Obligor, constitute
interests in a discrete pool of financial assets which can be evaluated
by plan fiduciaries who have available to them a large body of
historical data as to the performance of various types of ABS/MBS
issued by many different issuers. Fiduciaries are also able to monitor
the performance of the pool of assets supporting payments on the ABS/
MBS on a contemporaneous basis, as investors are given monthly reports
on collections, account balances, credit support levels and the status
of the receivables. All of these points are discussed in greater detail
below.
[[Page 51469]]
B. Reliance on Ratings
1. Background
The Applicant notes that when the Underwriter Exemptions originally
were applied for in the mid-1980s, public and private offerings of ABS
and MBS by private sector originators had only recently been introduced
in the United States capital markets. The Applicant states that the
Department, in granting exemptive relief under the original Underwriter
Exemptions, was cognitive of the relative infancy of private sector
ABS/MBS transactions when it originally considered the extent to which
reliance should be placed on the determinations of the Rating Agencies
in establishing the boundaries of exemptive relief. For example, in the
Notice of Proposed Exemption relating to Application D-6555 made by
First Boston Corporation, 53 FR 52851 at 52857 (December 29, 1988) the
Department stated:
After consideration of the representations of the applicant and
the information provided by S&P's, Moody's and D&P, the Department
has decided to condition exemptive relief upon the certificates in
which a plan invests having attained a rating in one of the three
highest generic rating categories from S&P's, Moody's or, in the
case of certificates representing interests in trust containing
multi-family residential mortgages or commercial mortgages, D&P.
The Department believes that the rating condition will permit
the applicant flexibility in structuring trusts containing a variety
of mortgages and other receivables, while ensuring that the
interests of plans holding certificates are adequately protected. In
particular, in rating certificates, S&P's, Moody's and D&P take into
account such factors as commingling of funds and conflicts of
interest of the trust sponsor and servicer.
However, the Department is not prepared to rely solely on
determinations made by these rating agencies in providing exemptive
relief. In this regard, the applicant originally requested that
exemptive relief apply to trusts containing any type of receivable--
secured or unsecured--provided that the rating condition is met.
The Department is not prepared at this time to grant such broad
exemptive relief. The Department believes that the rating agencies
currently have more expertise in rating certificates representing
interests in secured, as opposed to unsecured, receivable trusts.
Consequently, the Department believes that the ratings are more
indicative of the relative safety of the investment when applied to
trusts containing secured receivables.
Moreover, First Boston has represented that trusts containing
different types of receivables are continuously being developed and
rated. While the Department would generally prefer to be more
specific as to the types of assets contained in the trusts, the
Department recognizes the applicant's need for flexibility. At the
same time, the Department believes that it is appropriate to ensure
that the rating agencies have developed expertise in rating a
particular type of asset-backed security and that such security has
been tested in the marketplace prior to plan investment pursuant to
this exemption. Consequently, the Department has further conditioned
the proposed exemptive relief upon each particular type of asset-
backed security having been rated in one of the three highest rating
categories for at least one year and having been sold to investors
other than plans for at least one year.
2. Rating Agency Expertise
The Applicant asserts that since the time of the First Boston
Corporation application, the Rating Agencies have developed an enormous
depth of experience in rating ABS/MBS due to the extensive growth of
these markets. Since that time, investment-grade ratings have been
assigned to a broad range of asset classes and transaction structures
in the ABS/MBS markets. The Applicant notes that those ratings, and the
credit quality of underlying collateral, have been the subject of
continuing surveillance and active scrutiny by the Rating Agencies and
that the historical performance record of these offerings clearly
demonstrates that the Rating Agencies have developed the expertise
necessary for the Department to conclude that ratings are extremely
reliable indicators of the relative safety of the securities and the
transactions with respect to which exemptive relief is requested.
3. Growth in the ABS/MBS Markets
According to the Applicant, ABS/MBS now constitute a major segment
of the fixed-income marketplace. This growth, which is manifested in a
rapid increase in issuance levels and the continuing entry and
acceptance of new issuers, asset types and transaction structures into
the market, has generated an accompanying growth in market depth,
liquidity and efficiency.
The first pass-through security was issued in 1970, with a
guarantee by Ginnie Mae. Soon, Freddie Mac and Fannie Mae began issuing
mortgage securities as well. The development of the collateralized
mortgage obligation (CMO) in 1983 expanded the market for mortgage
securities by establishing a product appealing to a broad range of
investors with various investment time frames and cash-flow needs. As a
result of tremendous growth in the primary housing credit market and an
increasing level of investor interest and comfort in these investments,
the mortgage securities market is now one of the largest financial
markets in the world. Total volume of outstanding agency mortgage
securities exceeded $2.0 trillion at the end of 1998, as compared to
the $372.1 billion outstanding level at year-end 1985. New issuance of
agency pass-throughs totaled $726.9 billion in 1998, while agency CMO
issuance reached $225.1 billion for the year. This compares to the
$111.1 billion in agency pass-throughs issued in 1985. Private label
CMO issuance was $135 billion in 1998. In contrast, total issuance in
the corporate bond market was $678 billion in 1998.
Asset-backed securities constitute a relatively newer but fast-
growing segment of the debt markets. The first ABS were issued in 1985,
with the new issue dollar volume reaching $1.2 billion in that year. In
comparison, $197.6 billion in ABS were issued in 1998, while the
outstanding level of ABS was an estimated $630 billion at the end of
the year. The ABS market has grown dramatically since its inception in
the mid-1980s and has become a basic financing mechanism in the debt
capital markets, with rapid domestic and international growth. Strong
investor demand and the diversity of securities available have helped
to fuel the growth in the ABS market.
The home equity, credit card and auto loan sectors are the
mainstays of the ABS market. However, the strength in home equity-
backed issuance has been the driving force behind the growth in ABS
issuance in the past few years. This sector maintained its dominance in
1998, with volume representing 41.9% of total issuance in the period.
Issuance in the home equity sector totaled $82.8 billion in 1998, a
28.7% increase over the $64.4 billion sold in 1997. Issuance in the
credit card sector was relatively flat in 1998, with volume totaling
$37.1 billion, essentially unchanged from 1997's $37.5 billion. Auto
loan ABS issuance rose by 6.0% in 1998, totaling $35.1 billion, as
compared to the $33.1 billion issued in 1997.
Commercial mortgage-backed securities (CMBS) issuance has grown
sharply in recent years. Approximately 20% of all real estate debt is
now securitized and held in the hands of investors in the form of CMBS.
Standardization of loan structures, growing investor acceptance and the
changing regulatory environment have all contributed to the market's
growth. Issuance in the CMBS market increased by more than tenfold over
the past eight years. CMBS issuance jumped sharply in 1998 with volume
increasing to a record $78.3 billion in 1998, a 78.0% increase over the
$44.3 billion reported in 1997 and 162.8% greater than the $29.8
billion issued in 1996. In
[[Page 51470]]
comparison, CMBS issuance totaled just $6.0 billion in 1990.
4. Congressional and Agency Reliance on Ratings
The Applicant states that Congress and governmental regulatory
agencies rely on the efficacy of the rating process for many purposes.
The United States Securities and Exchange Commission (the ``SEC'') has
relied frequently on ratings assigned by a ``nationally recognized
statistical rating organization'' (NRSRO). Two prime reasons that the
ABS/MBS market has grown dramatically over the past five years are the
ability to offer investment-grade asset-backed securities to the public
on a shelf registration statement and changes to the Investment Company
Act of 1940. With a shelf registration, the SEC review and comment
period occurs prior to effectiveness of the registration statement.
Thereafter, an issuer can sell securities on an expedited basis. No
additional SEC review is necessary. However, each security offered on a
shelf must be rated by at least one NRSRO in one of its four highest
generic rating categories. The Investment Company Act of 1940 was a
major impediment in developing the ABS/MBS markets. Absent an
exemption, substantially all of the Trusts and other vehicles issuing
ABS would be required to register as an ``investment company'' under
this Act. Congress and the SEC realized that the securitization markets
could not function as regulated investment companies. As a result, Rule
3a-7 under the Investment Company Act was enacted in 1992. If the
conditions of this rule are satisfied, an issuer of ABS/MBS is not
deemed to be an investment company. One requirement of the rule is that
any security sold to investors (other than accredited investors or
qualified institutional buyers) be rated, at the time of sale, in one
of the four highest generic categories by at least one NRSRO.
5. Securities Ratings
The Securities in transactions which are not Designated
Transactions (as described below) will have received one of the three
highest generic ratings available from a Rating Agency. Insurance or
other credit support (such as surety bonds, letters of credit,
guarantees or overcollateralization) will be obtained by the Sponsor to
the extent necessary for the Securities to attain the desired rating.
The amount of this credit support is set by the Rating Agencies at a
level that is typically a multiple of the worst historical net credit
loss experience for the types of obligations included in the Issuer.
6. The Rating Process
Ratings on a class of Securities are an evaluation by the Rating
Agency of the credit, structural and legal risks of a transaction,
which is made to help predict the probability of an investor receiving
timely payment of interest and payment of principal by the maturity
date of the Securities. Ratings generally do not address risks arising
from interest rate fluctuations or prepayments of the underlying
obligations by borrowers. In order to make their assessment of a class
of Securities, the Rating Agencies perform sophisticated analyses of
the predicted frequency and severity of losses on the pool of
obligations by conducting extensive investigative due diligence reviews
of both the originator and assets to be securitized, sampling the asset
pool or performing a review of the entire asset pool, comparing the
expected performance of that particular pool against historical
performance of pools containing similar assets (either from the same
originator or based upon industry standards) and making determinations
of the adequate levels of credit enhancement required to support each
rating level. For all investment-grade ratings, including ``BBB,'' the
credit support levels are set to require the transaction to withstand
not just expected losses on the pool of assets but a multiple of such
projected losses (or, in some cases, a more severe economic default
model). Regression analysis is continually performed whereby the Rating
Agencies determine how factors such as LTV ratios, geographic
diversity, strength of borrower's credit history, type of loan and
other factors correlate positively or negatively with both loss
frequency and severity in order to predict how a pool will perform. The
particular asset type is of primary importance in determining the
nature and scope of the diligence review. Also, the type of asset will
determine the type of legal and structural safeguards that must be
implemented to safeguard the interests of the related securityholders
and permit the issuance of the applicable rating.
The Rating Agencies differ slightly in what they consider their
ratings to represent. Specifically, Moody's ratings express an opinion
of the amount by which the internal rate of return in a diversified
portfolio of similarly rated Securities would be reduced as a result of
defaults on the Securities. For example, ``Aaa'' rated Securities held
to maturity without any changes in rating are expected to suffer a
reduction in realized yield over a ten-year period of less than one
basis point (i.e., 1/100th of a percent); 1-3 bps for an ``Aa'' rating;
5-13 bps for an ``A'' rating; 20-50 bps for a ``Baa'' rating; 75-150
bps for a ``Ba'' rating and 175-325 bps for a ``B'' rating.
Accordingly, the expected reduction in yield for all investment-grade
Securities, whether or not subordinated, is 0.5% or less, and as
indicated below, for Securities has turned out to be virtually zero.
The ratings of the three other Rating Agencies express an opinion on
the probability that no losses will be experienced on the Securities in
different rating categories. However, any slight differences in the
technical meaning of a rating are not considered to be of any material
significance in the capital markets.
The rating process generally rates to the ``weakest link'' in that
if credit support is provided for by a third party, the rating given to
the Securities cannot exceed that of the credit support provider. In
addition, the Rating Agencies may also require minimum credit ratings
of other parties to the transactions such as the Servicer, back-up
Servicers and pool Insurers and, at a minimum, the credit strength of
such parties is factored into the analysis of the pool when projecting
losses.
7. Reasons to Extend Relief to Subordinated ABS/MBS and High LTV
Receivables
As support for the requested modifications, the Applicant notes
that the Department already has permitted securities with ratings of
``A'' or better to be eligible for relief under the Underwriter
Exemptions, although, in particular transactions, the credit quality of
the borrowers who are obligated on the loans held as Trust assets may
be less than A.\28\ Many securities issued in securitization
transactions receive ``AAA'' ratings even if the borrowers on the loans
have B and C credit. This risk is addressed by requiring greater credit
support using conservative stress tests.
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\28\ The applicant notes that borrowers are frequently
categorized by originators as being of A, B, C or D credit quality,
although other designations may be used.
---------------------------------------------------------------------------
The Applicant asserts that subordinated securities and higher LTV
ratio collateral for transactions in those rating and asset categories
already approved by the Department would be equally as protective of
plan investors as those transactions currently permitted with non-
subordinated and lower LTV ratios. Granting this relief would also
address the anomaly which now exists
[[Page 51471]]
where an ``A'' rated senior security is currently eligible for
exemptive relief, but an ``AAA'' rated subordinated security or a
senior security issued by a Trust with less than fully secured loans is
not. While this anomaly developed because of the Department's concerns
as to whether the Rating Agencies had the requisite experience to rate
certain types of ABS/MBS, the market has developed to a point where
this distinction is no longer necessary to protect plan investors. The
ratings quantify the credit risk of a transaction at various rating
levels, and any deficiencies in the credit quality of the assets, the
credit of the borrowers, the strength of the parties to the transaction
or the structure are factored into the credit support requirements,
with the result that every rating of the same letter designation
represents the same credit quality of a security without regard to the
particular features of any single transaction. In this regard, at the
request of the Department, the Applicant has provided letters from the
Rating Agencies confirming their view to this effect.
The Applicant states that the need for flexibility is nowhere
better exemplified than in the inclusion of subordinated securities in
the type of securities eligible for exemptive relief. Transactions in
the 1980s typically did not feature investment-grade subordinated
securities. In contrast, the market has now evolved to the point where
ABS/MBS offerings typically include multiple tranches of senior and
subordinated investment-grade securities. In common market terminology,
in transactions where there are two or more subordinated classes of
securities, ``AAA'' rated ABS/MBS classes are described as ``senior''
classes, ``AA'' through ``BBB'' subordinated classes are described as
``mezzanine'' classes, and sub-investment-grade classes are described
as ``subordinated'' classes. In other transactions, the ``AAA'' and
``AA'' classes may be referred to as senior, and the ``BBB'' class or
classes may be referred to as either mezzanine or subordinated,
depending on the number of classes and the structure. In contrast,
under the current Underwriter Exemptions, all classes of ABS/MBS below
the most senior ``AAA'' class are regarded as subordinated.
The Applicant believes that Rating Agencies can rate subordinated
classes of securities with a high level of expertise, thereby ensuring
the safety of these investments for plans through the use of other
credit support (including increased levels of non-investment-grade
securities). The subordination of a security, while factored into the
evaluation made by the Rating Agencies in their assessment of credit
risk, is not indicative of whether a security is more or less safe for
investors. In fact, there are ``AAA'' rated subordinated
securities.\29\ Subordination is simply another form of credit support.
The Rating Agencies, after determining the level of credit support
required to achieve a given rating level, are essentially indifferent
as to how these credit support requirements are implemented--whether
through subordination or other means. If subordination is used,
however, the subordinated class will have no greater credit risks or
fewer legal protections in comparison with other credit-supported
classes that possesses the same rating.
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\29\ For example, a transaction may have two classes of ``AAA''
rated securities and one is subordinated to the other. The
subordinated class would be required to have more credit support to
qualify for the ``AAA'' rating than the more senior ``AAA'' rated
class.
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According to the Applicant, there is much benefit to plan investors
in having subordinated securities eligible for exemptive relief. First,
credit support provided through third-party credit providers is more
expensive than an equal amount of credit support provided through
subordination. As a result, the ability to use subordinated tranches to
provide credit support for the more senior classes (which may or may
not themselves be subordinated) creates economic savings for all the
parties to the transaction which, in turn, can allow greater returns to
investors. In addition, if the credit rating of a third-party credit
support provider is downgraded, the rating of the securities is also
downgraded. Second, the yields available on subordinated securities are
often higher than those paid on comparably rated non-subordinated
securities because investors expect to receive higher returns for
subordinated securities. Third, subordinated securities are usually
paid after other more senior securities, which results in their having
longer terms to maturity. This is appealing to many investors who are
looking for medium-term fixed income investments to diversify their
portfolios. The combination of these factors benefits investors by
making available securities which can provide higher yields for longer
periods. It should be noted that as the rating of a security generally
addresses the probability of all interest being timely paid and all
principal being paid by maturity under various stress scenarios, the
Rating Agencies are particularly concerned with the ability of the pool
to generate sufficient cash flow to pay all amounts due on subordinated
tranches, and several features of the credit support mechanisms
discussed below are designed to protect subordinated classes of
securities.
8. Performance of Investment-Grade ABS/MBS
The Applicant asserts that the arguments articulated for the safety
of subordinated securities or securities issued by entities holding
loans with high LTV ratios are supported by the statistics. Ratings
have proven to be a remarkably accurate prognosticator of the
probability of default on ABS/MBS and also support the appropriateness
of extending exemptive relief to ``BBB'' rated securities. Accompanying
the tremendous growth of the asset-backed and mortgage-backed markets
has been a stellar record of repayment of principal and interest. After
extensive investigative efforts and interviews with Rating Agencies,
bond insurance companies and the TBMA dealer membership, the Applicant
has concluded that, to the best of its knowledge, there have been only
isolated instances of defaults on any investment-grade ABS/MBS.
During the three-year period from 1995-1997, 139 corporate issues
representing $22 billion in corporate bonds defaulted. Yet, corporate
bonds may be purchased by benefit plan investors without triggering
prohibited transactions pursuant to a number of prohibited transaction
class exemptions based on the identity of the plan investor or the
fiduciary making the investment decision on behalf of the plan
(``Investor-Based Exemptions'').\30\ Equity investments in any type of
corporate stocks (which can be highly speculative and have certainly
experienced significant losses) are also not restricted by the
prohibited transaction rules because of the operating company exception
under the Plan Asset Regulation, set forth at 29 CFR Sec. 2510-
3.101(c). Similarly, plans can invest in a commercial mortgage loan,
yet may not be able to invest in any investment-grade collateralized
MBS which carries far less credit risk. In addition, while there have
been rating downgrades of ABS/MBS, the ABS/MBS downgrade statistics are
vastly superior to the comparable statistics for corporate debt
instruments.
[[Page 51472]]
The Applicant states that the purpose in drawing these comparisons is
not to suggest that corporate bonds, commercial mortgage loans or any
other instruments are unsafe plan investments. Rather, the point is
that investment-grade ABS/MBS are equally as safe, if not safer,
investments than other alternatives presently available to plans under
various existing exemptions.
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\30\ These exemptions include (a) PTE 84-14, regarding
transactions negotiated by qualified professional asset managers;
(b) PTE 90-1, regarding investments by insurance company pooled
separate accounts; (c) PTE 91-38, regarding investments by bank
collective investment funds; (d) PTE 95-60, regarding investments by
insurance company general accounts; and (e) PTE 96-23, regarding
investments determined by in-house asset managers.
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The Applicant believes that investment-grade ABS/MBS are an
attractive investment alternative to plan fiduciaries. This is because
in most ABS/MBS transactions, credit risk is spread across many
Obligors instead of just one corporate borrower as would be the case
with the issuance of a corporate bond. At least one reason for this is
that if the Obligor on a corporate bond defaults, the bond holder will
not be paid in full, whereas in a securitization, even if a number of
the underlying obligations go into default, the holder of an
investment-grade security is still likely to receive payment because of
the size of the asset pool and/or credit support features of the
transaction. In addition, the returns on ABS/MBS are generally higher
than those paid on corporate debt instruments in comparable rating
categories in order to compensate investors for prepayment risk (i.e.,
the risk that an investor may receive a return of the principal it
invested earlier than anticipated).
The Applicant believes that allowing a greater proportion of ABS/
MBS to be eligible for relief under the Underwriter Exemptions is of
considerable benefit to plan participants and their beneficiaries
because it increases the access plans have to fixed income investments
with high credit quality as an alternative to corporate bonds and other
forms of investments. Plan fiduciaries have available to them a
significant amount of statistical data as to the historical performance
of ABS/MBS by asset type, investment rating and originator which can
assist them in evaluating the pool of assets being securitized. Plan
investors are also able to contemporaneously monitor the performance of
ABS/MBS because they are provided periodic reports in which they
receive, in general, the following information: the amount of principal
and source of principal (e.g., from regular loan principal payments,
prepayments or reserve accounts), the amount of interest, the status of
the payments on the underlying mortgages (e.g., are any 30, 60 or 90
days in arrears) and the status of the credit support (e.g.,
overcollateralization levels and reserve account balances).
C. Description of Rating Agencies' Due Diligence With Respect to
Parties Involved in Transactions
The Applicant states that the due diligence performed by the Rating
Agencies with respect to the parties to the transaction, such as the
Sponsor, Servicer, Trustee and Insurer, and their requirements
regarding these parties which are described below, are generally common
to all securitizations.
1. The Sponsor
The Rating Agencies do not have minimum credit rating requirements
for the Sponsor if it is not also acting as a Servicer because its
assets are not subject to the claims of the Issuer. However, the Rating
Agencies do apply a factor to the expected loss estimate for a pool of
mortgages or other assets based upon the quality of the Sponsor, and
they evaluate the Sponsor's underwriting standards and operations in
order to determine the general financial stability of the Sponsor. Such
an evaluation provides an indication of the credit quality of the
assets being securitized. An on-site investigation may be made,
including meetings with management. This will generally include a
review of the operations, policies and procedures of the Sponsor,
including the quality and completeness of loan documentation. For
example, the historic and current lending criteria of the Sponsor,
including the Sponsor's policies regarding allowing extensions of
payment schedules, renegotiating contracts, granting grace or cure
periods and loan liquidation procedures, will be reviewed. Its manner
of competing in the market for borrowers is also examined (e.g., to see
whether borrowers are sought without conducting adequate review of
their finances and whether the Sponsor has adequate capital to support
a growing loan portfolio and its access to bank financing or other
sources of liquidity). Historic delinquency rates with respect to the
Sponsor's receivables will generally also be examined, as will the
underwriting standards of the Sponsor (i.e., evaluating the credit of
potential borrowers within stated lending guidelines and the use of
credit checks). If such guidelines are applied consistently, the
Sponsor's historical record may be helpful in predicting future
performance of the loan portfolios. The information presented by the
Sponsor will also be evaluated in order to determine the overall
stability of the Sponsor, including its historic and expected financial
performance, its organizational strengths and weaknesses and its
competitive position. The importance of the financial stability of the
Sponsor in determining the overall rating of the securitization
transaction will depend on determination of the correlation between the
performance of the receivables and any fundamental risks inherent in
the Sponsor's business operations. The process by which the receivables
are chosen for a transaction is also reviewed in order to ensure that
the pool represents either a random sampling or quality-oriented
sampling of the Sponsor's receivables and not predominately lower-
quality receivables.
2. The Servicer
(a) Review of Servicer's Operations--The Servicer is required to
service the receivables held by an Issuer. The Rating Agencies,
therefore, perform a thorough evaluation of the Servicer as part of
their evaluation of the general credit risk of a particular
transaction. A complete review of the Servicer is conducted beginning
with its formation. If it has been in business for less than three to
five years or has shown weak portfolio performance, bond insurance for
the Securities offered may be required providing full coverage against
borrower defaults. The management of the Servicer is reviewed to assess
the experience, character and integrity of management. The Rating
Agencies will also conduct a review of the Servicer's operations and
capabilities, such as the degree to which the recordkeeping and
collection process is automated, the internal audit and review systems,
capacity constraints, fraud prevention procedures and collection
methods. The evaluation of the Servicer usually involves an on-site
visit, including a meeting with management to discuss procedures,
methodology, past history and future financial outlook. High-quality
servicing provides investor protection which is required in order for a
high rating of the Securities and, conversely, low-quality servicing
could lower a rating.
(b) Collection and Handling of Funds--The Servicer will usually be
in the asset servicing business and may, therefore, have responsibility
for the assets of many securitization transactions. Often operating
efficiencies require that payments be made to one source and then be
allocated to the individual Issuers. This central collection feature
causes short-term commingling of assets. Accordingly, unless the
Servicer is highly rated, the Rating Agencies will require the servicer
to transfer all collections it receives in the course of its acting as
a servicer for different issuers to segregated accounts for each
[[Page 51473]]
issuer which are held at highly rated banks within two to three days of
receipt. The Rating Agencies also examine the effect that bankruptcy or
other insolvency would have on the Servicer's ability to service the
loans or advance funds to pay securityholders or pay other required
fees.
(c) Payment Support Features--As part of its servicing
responsibilities, the Servicer may also be required to provide two
payment support features to the securityholders. The first is a
liquidity facility or monthly advance requirement, and the second is a
``compensating interest'' feature. The overall credit quality of the
Servicer affects the Servicer's ability to perform these functions.
Accordingly, if a Servicer provides financial support, the Rating
Agencies prefer that such Servicer have a rating which is not lower
than the rating to be assigned to the Securities. If the Servicer's
rating is lower, additional protections may be required, such as
requiring the Servicer to obtain a surety bond, letter of credit or
other rated credit support for its financial support.
(i) Servicer Advances--Where advancing is required, the Servicer is
generally required to advance funds to the Issuer in an amount equal to
delinquent payments of interest and, in some transactions principal, to
the extent that the Servicer believes that these amounts may be
recovered from subsequent payments and collections. If an Obligor is
late in making payments, the Servicer will advance the funds to the
Issuer. The Servicer is entitled to a return of these funds from future
collections. The Servicer is essentially making an interest-free loan
to the Issuer, but it is the Issuer that bears the ultimate risk of
loss. An alternative to Servicer advancing is an advance claims payment
provision. An advance claims payment provision is an insurance policy
that guarantees timeliness of payments to the securityholders. In
addition, the Rating Agencies require errors and omissions insurance in
at least the amount of the maximum cash balance anticipated to be in
the Issuer's accounts held by the Servicer, Issuer, paying agent or
other agent covering potential losses arising from errors and omissions
of officers, directors and employees of such transaction participants
to the extent they have access to Issuer funds.
(ii) Servicer Compensating Interest--When an Obligor on a mortgage
loan or other prepayable asset makes a prepayment (either full or
partial) on the obligation, interest is only required to be paid that
month up until the date of the prepayment, but the securityholder is
entitled to a full month's interest on that loan. The Servicer may be
required to fund the difference between a full month's interest on such
prepaid loan and the interest actually received from the Obligor. The
Servicer is generally only required to make such compensating interest
payments in amounts that will not exceed its servicing compensation for
that month.
(d) Successor Servicers and Subservicers--Transaction documents
will provide for the appointment of a successor Servicer if the
original Servicer is deemed unable to perform its required duties.
Typically, a Trustee with an acceptable rating may act as a back-up
Servicer by assuming an obligation to perform the servicing function in
the event of a default by the Servicer. However, a Servicer is not
permitted to resign voluntarily until a replacement is appointed.
Servicing compensation is also set at a level so that a successor
Servicer will be adequately compensated for assuming such servicing
responsibilities. Transaction documentation may also allow the Servicer
to subcontract some or all of its servicing obligations to qualified
Subservicers. While these Subservicers may perform the actual servicing
work on a selected portion of the pool of assets, the Servicer remains
responsible for the ultimate performance of the servicing activities
and is liable for any failure to adequately perform the required
servicing duties.
Prior to the transfer of servicing responsibilities to a successor
Servicer and prior to a merger or consolidation affecting the Servicer,
the parties to the transaction must obtain the Rating Agency's written
confirmation that the rating of the rated Securities in effect
immediately prior to the transfer of servicing responsibilities will
not be qualified, downgraded or withdrawn as a result of such
resignation, merger or other transfer. Typically, a Servicer may
voluntarily resign only upon a determination that the performance of
its servicing duties under the servicing agreement is no longer
permissible under applicable law and appointment by the Trustee or
securityholders of, and acceptance by, a successor Servicer. A Servicer
may be forced to resign by the Trustee or securityholders if the
continuation of the Servicer's servicing responsibilities would result
in the qualification, downgrade or withdrawal of the rating assigned to
the Securities or in the event of a default of the Servicer's
obligations under the Pooling and Servicing Agreement.
(e) Reports to Investors--The Servicer will be responsible for
preparing periodic reports on the performance of the pool of assets
containing such information as: beginning principal balance, ending
principal balance, the allocation of payments received between interest
and principal, scheduled principal payments, prepayments received,
delinquencies and status of various categories of delinquent accounts
(e.g., number of accounts 30-59 days, 60-89 days and 90 or more days
delinquent), defaults, foreclosures, if any, and other relevant
information for the related Trustee. The Trustee will utilize this data
in preparing the reports to securityholders.
3. The Trustee
The Trustee is also examined by the Rating Agencies to ensure that
credit problems of the Trustee do not affect the Issuer. Monies
received by the Issuer from the Servicer must be immediately deposited
into segregated accounts earmarked for the Issuer so that no
commingling occurs in the hands of the Trustee. If these funds are to
be invested, they only may be invested in instruments that have been
rated at a level specified by the Rating Agency as acceptable for the
rating given to such Securities (a ``Rating Condition''). Transaction
documentation will specify a list of permitted investments acceptable
to the applicable Rating Agencies. Typical examples of permitted
investments include the following: (a) Direct obligations or
obligations guaranteed by the United States or an agency or
instrumentality thereof; (b) demand or time deposits, federal funds or
bankers' acceptances issued by banks or trust companies that are
subject to federal and/or state banking authorities (subject to the
Rating Condition or FDIC insurance); (c) repurchase obligations with
respect to (a) and (b) above; (d) discount or interest-bearing
Securities issued by United States corporations that meet the
applicable Rating Condition; (e) commercial paper meeting the
applicable Rating Condition; and (f) money market funds or common trust
funds that meet the applicable Rating Condition.
The Trustee must be capable of performing the duties of the
Servicer in case the Servicer cannot perform its duties and a successor
has not been appointed. Transaction documentation will usually specify
minimum capital and surplus requirements for a Trustee and any
successor. As with the Servicer, adequate compensation for the services
performed by the Trustee will be provided for in the governing
documents. The Trustee is examined for its ability to administer
transactions; its
[[Page 51474]]
ability to assume successor Servicer responsibilities (or hire another
entity to do so); its plan to assume successor servicing, if necessary,
and whether its computer systems are compatible with the Servicer's
systems.
4. The Insurer
In transactions using third-party credit support, the rating of
Securities normally can be no higher than that of the claims-paying
ratings of the credit support provider. For this reason, selection of
an insurance company to provide advance claims payment insurance,
Security or bond insurance, pool insurance, mortgage insurance or
special hazard insurance is an important element in the structuring of
a securitization transaction. In assessing the credit of mortgage
insurance companies, the Rating Agencies make a number of
determinations as part of their review. The review includes a
determination of standing with the applicable state insurance
commission, adequacy of surplus and contingency reserves, historic
underwriting performance and operating profitability, quality of
investment portfolio, quality in management and internal control and
secondary support, such as reinsurance policies. Similar factors are
considered in the assessment of the claims-paying ability of Security
or bond insurance providers.
D. Types of Credit Support
Credit support consists of two general varieties: external credit
support and internal credit support. The Applicant notes that the
choice of the type of credit support depends on many factors. Internal
credit support which is generated by the operation of the Issuer is
preferred because it is less expensive than external credit support
which must be purchased from outside third parties. In addition, there
is a limited number of appropriately rated third-party credit support
providers available. Further, certain types of credit support are not
relevant to certain asset types. For example, there is generally little
or no excess spread available in residential or CMBS transactions
because the interest rates on the obligations being securitized are
relatively low. Third, the Ratings Agencies may require certain types
of credit support in a particular transaction. In this regard, the
selection of the types and amounts of the various kinds of credit
support for any given transaction are usually a product of negotiations
between the Underwriter of the securities and the Ratings Agencies. For
example, the Underwriter might propose using excess spread and
subordination as the types of credit support for a particular
transaction and the Rating Agency might require cash reserve accounts
funded up front by the Sponsor, excess spread and a smaller sized
subordinated tranche than that proposed by the Underwriter. In
addition, market forces can affect the types of credit support. For
example, there may not be a market for subordinated tranches because
the transaction cannot generate sufficient cash flow to pay a high
enough interest rate to compensate investors for the subordination
feature, or the market may demand an insurance wrap on a class of
securities before it will purchase certain classes of securities. All
of these considerations interact to dictate which particular
combination of credit support will be used in a particular transaction.
1. External Credit Support
In the case of external credit support, credit enhancement for
principal and interest repayments is provided by a third party so that
if required collections on the pooled receivables fall short due to
greater than anticipated delinquencies or losses, the credit
enhancement provider will pay the securityholders the shortfall.
Examples of such external credit support features include: insurance
policies from ``AAA'' rated monoline \31\ insurance companies (referred
to as ``wrapped'' transactions), corporate guarantees, letters of
credit and cash collateral accounts. In the case of wrapped or other
credit supported transactions, the Insurer or other credit provider
will usually take a lead role in negotiating with the Sponsor
concerning levels of overcollateralization and selection of receivables
for inclusion into the pool as it is the Insurer or credit provider
that will bear the ultimate risk of loss. As mentioned above, one
disadvantage of insurance, corporate guarantees and letters of credit
is that they are relatively expensive in comparison with other types of
credit support. Also, if the credit rating of the insurance company or
other credit provider is downgraded, the rating of the Securities is
correspondingly downgraded because the Rating Agencies will only rate
the Securities as highly as the credit rating of the credit support
provider. In any event, credit support providers require that each
class of Securities they insure be ``shadow rated'' no lower than
``BBB.'' A shadow rating is the rating that the Securities would have
received from the Rating Agency if the class of Securities had not been
wrapped, and the Rating Agency will provide a letter addressed solely
to the credit support provider verifying such rating. However, there
are only a handful of ``AAA'' monoline insurance providers, and
investors do not want to have too high a concentration of Securities
which are backed by such Insurers. There are also few providers of
letters of credit or corporate guarantees that have sufficiently high
long-term debt credit ratings. These disadvantages are some of the
reasons why subordination is often used as an alternative form of
credit support. Cash collateral accounts include reserve accounts which
are funded, usually by the Sponsor, on the Closing Date and are
available to cover principal and/or interest shortfalls as provided in
the documents.
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\31\ The term ``monoline'' is used to describe such insurance
companies because writing these types of insurance policies is their
sole business activity.
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2. Internal Credit Support
Internal credit support relies upon some combination of utilization
of excess interest generated by the receivables, specified levels of
overcollateralization and/or subordination of junior classes of
Securities. Transactions that look almost exclusively to the underlying
pooled assets for cash payments (or ``senior/subordinated''
transactions) will contain multiple classes of Securities, some of
which bear losses prior to others and, therefore, support more senior
Securities. A subordinate Security will absorb realized losses from the
asset pool, and have its principal amount ``written down'' to zero,
before any losses will be allocated to the more senior classes. In this
way, the more senior classes will receive higher rating classifications
than the more subordinate classes. However, the Rating Agencies require
cash flow modeling of all senior/subordinated structures. These cash
flows must be sufficient so that all rated classes, including the
subordinated classes, will receive timely payment of interest and
ultimate repayment of principal by the maturity date. The cash flow
models are tested assuming a variety of stressed prepayment speeds,
declining weighted average interest payments and loss assumptions.
Other structural mechanisms to assure payment to subordinated classes
are to allow collections held in the reserve account for the next
payment date to be used if necessary to pay current interest to the
subordinated class or to create a separate interest liquidity reserve.
The collections held in the reserve account are from principal and
interest paid on the underlying mortgages or other receivables held in
the Issuer and are not from the securities issued by the
[[Page 51475]]
Issuer.\32\ Also, some structures allow both principal and interest to
be applied to all payments to securityholders, and in others, principal
can be used to pay interest to the subordinate tranches.
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\32\ A collections reserve account is established for almost all
transactions to hold interest and principal payments on the
mortgages or receivables as they are collected until the necessary
amounts are paid to securityholders on the next periodic
distribution date. In some transactions, the Rating Agencies or
other interested parties may require, in order to protect the
interests of the securityholders, that excess interest in amount(s)
equal to a specified number of future period anticipated collections
be retained in the collection account. This protects both senior and
subordinated securityholders in situations where there are
shortfalls in collections on the underlying obligations because it
provides an additional source of funds from which these
securityholders can be paid their current distributions before the
holders of the residual or more subordinated securities receive
their periodic distributions, if any. Accordingly, any reference to
``collections'' from principal and interest paid on the mortgages is
intended to describe such excess interest or principal not required
to cover current payments to the senior and subordinated class
eligible to be purchased by plans. Thus, this mechanism is not
harmful to the interests of senior securityholders.
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Interest which is received but is not required to make monthly
payments to securityholders (or to pay servicing or other
administrative fees or expenses) can be used as credit support. This
excess interest is known as ``excess spread'' or ``excess servicing''
(``Excess Spread'') and may be paid out to holders of certain
Securities, returned to the Sponsor or used to build up
overcollateralization or a loss reserve. The credit given to Excess
Spread is conservatively evaluated to ensure sufficient cash flow at
any one point in time to cover losses. The Rating Agencies reduce the
credit given to Excess Spread as credit support to take into account
the risk of higher coupon loans prepaying first, higher than expected
total prepayments, timing mismatching of losses with Excess Spread
collections and the amounts allowed to be returned to the Sponsor once
minimum overcollateralization targets are met (thereby reducing the
amounts available for credit support).
``Overcollateralization'' is the difference between the outstanding
principal balance of the pool of assets and the outstanding principal
balance of the Securities backed by such pool of assets. This results
in a larger principal balance of underlying assets than the amount
needed to make all required payments of principal to investors. In all
senior/subordinated transactions, the requisite level of
overcollateralization and the amount of principal that may be paid to
holders of the more subordinated Securities before the more senior
Securities are retired (since once such amounts are paid, they are
unavailable to absorb future losses) is determined by the Rating
Agencies and varies from transaction to transaction, depending on the
type of assets, quality of the assets, the term of the Securities and
other factors.
The senior/subordinated structure often combines the use of
subordinated tranches with overcollateralization that builds over time
from the application of excess interest to pay principal on more senior
classes. This is often referred to as a ``turbo'' structure. The credit
enhancement for each more senior class is provided by the aggregate
dollar amount of the respective subordinated classes, plus
overcollateralization that results from the payment of principal to the
more senior classes using excess spread prior to payment of any
principal to the more subordinated classes. As overcollateralization
grows, the pool of loans can withstand a larger dollar amount of losses
without resulting in losses on the senior Securities. This also has the
effect of increasing the amount of funds available to pay the more
subordinated classes as an ever-decreasing portion of the principal
cash flow is needed to pay the more senior classes. Excess interest is
used to pay down the more senior Security balances until a specific
dollar amount of overcollateralization is achieved. This is referred to
as the overcollateralization target amount required by the Rating
Agencies. Typically, the targeted amount is set to ensure that even in
a worst-case loss scenario commensurate with the assigned rating level,
all securityholders, including holders of subordinated classes, will
receive timely payment of interest and ultimate payment of principal by
the applicable maturity date. In these transactions, the targeted
amount is usually set as a percentage of the original pool balance. It
may be reduced after a fixed number of years after the Closing Date,
subject to the satisfaction of certain loss and delinquency triggers.
These triggers ensure that overcollateralization continues to be
available if pool performance begins to deteriorate. In a senior/
subordinated structure, every investment-grade class (whether or not
subordinated) is protected by either a lower rated subordinated class
or classes or other credit support.
E. Provision of Credit Support Through Servicer Advancing
In some cases, the Master Servicer, or an Affiliate of the
Servicer, may provide credit support to the Issuer (i.e., act as an
Insurer). In these cases, the Servicer will first advance funds to the
full extent that it determines that such advances will be recoverable
(a) out of late payments by the Obligors, (b) from the credit support
provider (which may be the Master Servicer or an Affiliate Servicer)
or, (c) in the case of an Issuer that issues subordinated Securities,
from amounts otherwise distributable to holders of subordinated
Securities, and the Master Servicer will advance such funds in a timely
manner. When the Servicer is a provider of the credit support and
provides its own funds to cover defaulted payments, it will do so
either on the initiative of the Trustee, or on its own initiative on
behalf of the Trustee, but in either event it will provide such funds
to cover payments to the full extent of its obligations under the
credit support mechanism. In some cases, however, the Servicer may not
be obligated to advance funds but instead would be called upon to
provide funds to cover defaulted payments to the full extent of its
obligations as Insurer. Moreover, a Master Servicer typically can
recover advances either from the provider of credit support or from the
future payments on the affected receivables.
If the Master Servicer fails to advance funds, fails to call upon
the credit support mechanism to provide funds to cover delinquent
payments, or otherwise fails in its duties, the Trustee would be
required and would be able to enforce the securityholders' rights as
both a party to the Pooling and Servicing Agreement and the owner of
the Trust estate where the Issuer is a Trust (or as the holder of the
security interest in the receivables), including rights under the
credit support mechanism. Therefore, the Trustee, who is independent of
the Servicer, will have the ultimate right to enforce the credit
support arrangement.
When a Master Servicer advances funds, the amount so advanced is
recoverable by the Master Servicer out of future payments on
receivables held by the Issuer to the extent not covered by credit
support. However, where the Master Servicer provides credit support to
the Issuer, there are protections, including those described below, in
place to guard against a delay in calling upon the credit support to
take advantage of the fact that the credit support declines
proportionally with the decrease in the principal amount of the
obligations held by the Issuer as payments on receivables are passed
through to investors. These protective safeguards include:
1. There is often a disincentive to postponing credit losses
because the sooner repossession or foreclosure activities are
commenced, the more value that can be realized on the security for the
obligation;
[[Page 51476]]
2. The Master Servicer has servicing guidelines which include a
general policy as to the allowable delinquency period after which an
obligation ordinarily will be deemed uncollectible. The Pooling and
Servicing Agreement will require the Master Servicer to follow its
normal servicing guidelines and will set forth the Master Servicer's
general policy as to the period of time after which delinquent
obligations ordinarily will be considered uncollectible;
3. As frequently as payments are due on the receivables held by the
Issuer, as set forth in the Pooling and Servicing Agreement (typically
monthly, quarterly or semi-annually), the Master Servicer is required
to report to the independent Trustee the amount of all payments which
are past due more than a specified number of days and the amount of all
Servicer advances, along with other current information as to
collections on the assets and draws upon the credit support. Further,
the Master Servicer is required to deliver to the Trustee annually a
certificate of an executive officer of the Master Servicer stating that
a review of the servicing activities has been made under such officer's
supervision, and either stating that the Servicer has fulfilled all of
its obligations under the Pooling and Servicing Agreement or, if the
Master Servicer has defaulted under any of its obligations, specifying
any such default. The Master Servicer's reports are reviewed at least
annually by independent accountants to ensure that the Master Servicer
is following its normal servicing standards and that the Master
Servicer's reports conform to the Master Servicer's internal accounting
records. The results of the independent accountant's review are
delivered to the Trustee; and
4. The credit support has a ``floor'' dollar amount that protects
investors against the possibility that a large number of credit losses
might occur towards the end of the life of the Issuer, whether due to
Servicer advances or any other cause. Once the floor amount has been
reached, the Servicer lacks an incentive to postpone the recognition of
credit losses because the credit support amount becomes a fixed-dollar
amount, subject to reduction only for actual draws. From the time that
the floor amount is effective until the end of the life of the Issuer,
there are no proportionate reductions in the credit support amount
caused by reductions in the pool principal balance. Indeed, since the
floor is a fixed-dollar amount, the amount of credit support ordinarily
increases as a percentage of the pool principal balance during the
period that the floor is in effect.
F. Description of Designated Transactions
The Applicant requests relief for senior and/or subordinated
investment-grade securities issued by Issuers with respect to a limited
number of asset categories: Motor vehicles, residential/home equity,
manufactured housing and CMBS. Accordingly, the Applicant has provided
the Department with detailed, separate profiles of a typical
transaction for each asset category. Each profile describes
specifically how each type of transaction generally is structured, the
due diligence that the Rating Agencies conduct before assigning a
rating to a particular class of such securities, the calculations that
are performed to determine projected cash flows, loss frequency and
loss severity and the manner in which credit support requirements are
determined for each rating class. The motor vehicle, residential/home
equity, manufactured housing and commercial ABS/MBS transactions, as
described in this section will collectively be referred to as
``Designated Transactions.'' \33\
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\33\ The modifications requested with respect to the type of
securitization vehicle (i.e., both Trust and non-Trust) and type of
security (both debt and equity securities) or the use of interest
rate swaps or yield supplement agreements with notional principal
amounts would be applicable to both Designated Transactions and all
other types of asset categories currently permitted under the
Underwriter Exemptions.
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Each of the four types of Designated Transactions is already
encompassed within the existing asset categories. Specifically:
(i). Automobile and other motor vehicle ABS would principally fall
within category III.B.(1)(d) obligations that are secured by motor
vehicles or equipment but could also be covered under category
III.B.(1)(a) secured consumer receivables or III.B.(1)(b) secured
credit investments between business entities, depending on the factual
situation.
(ii). Home equity and residential ABS/MBS would fall within
categories III.B.(1)(a) which specifically refers to home equity loans
and III.B.(1)(c) which specifically refers to single-family residential
real property.
(iii). Manufactured housing would fall within category III.B.(1)(a)
if the manufactured housing is considered to be personal property under
local law, or within category III.B.(1)(c) if the manufactured housing
is considered real property under local law.
(iv). CMBS would fall within category III.B.(1)(c) which
specifically refers to multi-family residential and commercial real
property.
1. Motor Vehicle Loan Transactions
The Applicant asserts that many motor vehicle loan securitizations
are currently ineligible for exemptive relief under the Underwriter
Exemptions if such transactions have subordinated tranches,
notwithstanding being rated ``A'' or better. The Applicant notes that
in a typical motor vehicle transaction, ``AAA'' rated senior Securities
are issued that might represent approximately 90% or more of the
principal balances of the Securities, with ``A'' rated subordinated
Securities issued that might represent the remaining 10% or less of the
principal balance of the Securities. The total level of credit
enhancement from all sources, including Excess Spread, typically
averages approximately 7% of the initial principal balance of
Securities issued by prime issuers and 14% for subprime Issuers in
order to obtain an ``AAA'' rated Security. Credit support equaling 3%
for prime Issuers is usually required in order to obtain an ``A'' or
better rating on the subordinated Securities. Typical types of credit
support used in auto transactions are subordination, reserve accounts,
Excess Spread and financial guarantees from ``AAA'' rated monoline
insurance companies. Transactions with subprime Sponsors generally use
surety bonds as credit enhancement, so there is no subordinated class.
The Applicant states that as 70% of the motor vehicle
securitization market is attributable to automobile loans, the
following discussion principally relates to automobiles. (The term
``automobile'' as used herein also is intended to include light
trucks.) Other types of motor vehicles include boat loans, agricultural
equipment, construction equipment and recreation vehicles (RVs). The
Applicant is not requesting additional exemptive relief at this time
for motor vehicle leasing transactions or dealer floor plan financing.
The Applicant provided the following description of the analysis
performed by the Rating Agencies in their consideration of automobile
securitizations and their determination of appropriate credit support
requirements:
(a) Motor Vehicles--General Considerations--The credit rating of
the borrower in auto loan securitizations is much more important than
in real estate mortgage loan securitizations, where the value of the
collateral is one of the principal considerations. LTV ratios in auto
transactions increase over time due to the depreciation in value of the
automobiles over the term of the loan.
[[Page 51477]]
This makes it much more likely that borrowers will default if they fall
behind in their payments because they cannot pay off the loan with the
proceeds realized from selling the automobile. Accordingly, a
particularly intensive review of the underwriting policies and
procedures of the loan originators and the loss histories of each
originator is conducted in order to evaluate the predicted strength of
the borrowers. In addition, in order to insure timely payment to the
securityholders, the financial strength of the Sponsor/Servicer and its
operations and procedures, particularly with respect to how diligently
and timely it acts to monitor and correct late monthly payments and/or
to declare a default on the loan and repossess the collateral, are
closely scrutinized.
(b) Motor Vehicles--Due Diligence--The particular aspects of the
Rating Agencies' due diligence that are specific to motor vehicle
transactions are as follows. The originator's dealer network is
examined to determine the presence of any significant dealer
concentration, the composition of business across manufacturer
franchised new and used car dealerships, the selection process for new
dealerships, management tools to track performance by dealers, how
business is solicited and the methods used to prevent and detect dealer
fraud. Because the automobile sales market is extremely competitive,
companies are under pressure to meet certain growth targets. Therefore,
the Rating Agencies conduct an extensive review of the originator's
underwriting (loan approval) standards and monitoring controls. Both
the originator's underwriting criteria and the nature and frequency of
updates are examined. Factors included in this review are: how many
years of the borrower's credit history are considered; stability of the
borrower in job and residence; income levels; payment-to-income and
debt-to-income ratios; approval rates of origination; presence of
first-time buyers and whether and what type of credit scoring of
borrowers is performed.
(c) Motor Vehicles--Determination of Expected Losses--In order to
determine the correct amount of credit support which will be required
to support a particular rating for a class of auto loan Securities, a
base-case securitized pool loss assumption is calculated using the
following factors. Static pool data, if available, is compiled by
taking a discrete period of originations of the originator, such as a
financial quarter, and that pool's performance is tracked on a monthly
basis as the loans amortize, particularly focusing on loans which have
been outstanding (seasoned) 18-24 months and have been substantially
paid down. This allows a determination of the shape of the loss curve
and project timing of losses to be made. The cumulative net loss on the
less seasoned pools can then be extrapolated from the older pools.
Static pool data is preferred over active pool data, which can mask
losses during periods when the originator's pool of loans is rapidly
growing.
In creating the base-case expected loss amount, a detailed
breakdown of originations, delinquencies, repossessions, gross and net
losses and recoveries are examined. Any understatement of portfolio
losses are isolated and all originators are placed on a comparable
basis by dividing net annual losses by the outstanding principal
balance of a prior period, which creates a growth adjustment factor.
Once expected losses are estimated, the expected cumulative losses are
derived by multiplying these expected losses by the weighted average
life of the collateral, using conservative assumptions regarding losses
and prepayments.
The pool of loans selected for the securitization is examined in
order to assure that it is representative of the base-line loss
assumption for that originator and has not been selected from lesser-
quality receivables. The selection process used by the originator is
monitored by checking the annual percentage rate on the loans, the
principal amount of the loan, the LTV ratios, original maturity date of
the loans and remaining maturity, the new and used mix, the model year
and mileage of the vehicles, the amortization methods and geographic
concentrations. The characteristics of the borrowers are also examined
to monitor representative creditworthiness and stability by looking at
gross income, monthly debt service, debt-to-gross income ratio, down
payment-to-value ratio, years of credit history, credit scores, length
of time at the borrower's residence, employment term and past credit
problems to make sure that these criteria are representative of the
originator's broader portfolio. Credit scoring is a relatively new
method used by lending facilities to assess a borrower's likelihood of
repaying a loan. The Rating Agencies monitor the correlation between
such scores and actual losses to refine the appropriate weighting to be
given to credit scores.
Delinquency data is broken out over 30-day, 60-day and 90-day
groups, and delinquencies are examined based on the loan contract
terms. In order to make sure that default data is not misleading, the
Rating Agencies examine whether all loans that are not performing and
are not charged off (even if the debtor is in bankruptcy or where the
automobile has been repossessed) are considered to be in default. The
originator's charge-off policy and accounting method used to calculate
losses are examined, as the timing of the charge-off is important
because it affects loss statistics, and delays in charge-offs put
stress on liquidity.
(d) Special Factors Applicable to Motor Vehicles other than
Automobile--(i) Recreational Vehicles--The methodology used in
evaluating the credit quality of a pool of RV loans is very similar to
that used to assess auto loan pools but takes into account the fact
that the average RV Obligor is of higher credit quality than the
average auto loan Obligor. However, as RVs are generally regarded as
luxury items, buyers tend to default on them before debt obligations on
necessities. The characteristics of the RV Obligor base can vary widely
across pools, depending on such factors as the specific types of
vehicles in the pools and whether they are new or used, and therefore
must be evaluated on a case-by-case basis.
(ii) Boat Loans--Boat loan pools are similar in many ways to RV
loan pools as the underlying assets are luxury goods purchased by
persons who are generally more affluent than the average consumer.
However, there are some significant differences. There is an extremely
wide range of boats that can be purchased with costs ranging from a few
thousand dollars to more than $1 million. Consequently, the
characteristics of the obligations also span a wide range. Boat buyers,
especially those of small boats, tend to be younger than the typical RV
purchaser and are slightly higher credit risks. The resale value of
boats is highly seasonal, causing the recovery values on defaulted
loans to be highly variable. Finally, boats are produced by a large
number of generally small manufacturers. Accordingly, if a manufacturer
goes out of business, the resale value of its boats can decline sharply
since parts may be hard to replace; this increases the expected pool
losses and the variability of those losses. Second, there is an
increased risk of pool losses resulting from the bankruptcy of a
manufacturer; if the manufacturer has received the purchase price and
becomes bankrupt before delivery of the boat, the buyer may default on
the loan.
(iii) Agricultural Equipment--Special factors which are taken into
account in agricultural equipment (tractors and combines) (``AG'')
securitizations include the following. These loan
[[Page 51478]]
portfolios are particularly affected by commodity prices, weather,
financial stability of the borrower's business operations and
governmental price supports. Extensions granted for late payments are
also common in cases of floods, crop failures, etc., and for this
reason, geographic diversity in AG pools is especially desirable
because of varying weather patterns across the United States. Expected
losses are lower than those experienced in automobile transactions
because changes in the general economy do not affect frequency of AG
losses as much, and the equipment has a relatively stable value over
the life of the loans. However, the loss curve for AG securitizations
peaks much earlier than for auto loans, with 70% of defaults occurring
by 18 months, which is a significant factor in analyzing cash flows.
The size of the average AG loan is significantly higher than for other
motor vehicles, and the terms are longer (five to seven years). It is
not unusual for loan payments to be made only once per year to coincide
with income from annual harvests so the Rating Agencies are concerned
with an inability of Servicers to ascertain whether a borrower is in
financial difficulty as quickly. Because the condition of the equipment
is crucial to generating farm income, the strength of the dealer's
service department is also considered. On the other hand, companies
providing financing for AG dealers require such dealers to maintain
significant cash reserves against potential losses.
(iv) Construction Equipment Loans--The particular factors which
relate to construction equipment (``CE'') are as follows. CE includes
heavy equipment used in highway construction, forestry and mining and
includes, for example, back-hoes, bulldozers, excavators, truck loaders
and asphalt pavers. Unlike farm equipment, the health of the general
economy (and specifically housing starts, interest rates and public and
private project financing) impacts construction starts which directly
affects the Obligor's cash flow and thus loss frequency. In addition,
CE depreciates in value during the loan terms, and the amounts borrowed
are relatively large, which increases loss severity. Like AG equipment
loans, the equipment is needed to produce revenue so the Obligor has a
strong incentive to repay the loan. The cash flow of Obligors is often
seasonal, and although these loans pay monthly, losses can be sudden.
On the other hand, loans typically are structured to suspend payments
during winter months which lessens the frequency of defaults. Most
loans are serviced by rural businesses which negatively impacts on the
efficiency of the collection process. The loss curve for CE is also
early, with 70% of defaults occurring in the first 18 months. The terms
of a CE may not require any payments in the first six months of the
loan, depending on the time of year the loan was initiated, so
seasoning statistics need to be adjusted for this factor.
(e) Motor Vehicles--Determining Required Credit Support--The total
credit support required by the Rating Agencies for the desired ratings
of each class of Securities being offered must be sufficient to cover
certain pre-established loss multiples which are applied to a base-case
loss model. For example, a Rating Agency might require sufficient
credit support from all sources to be able to withstand five times the
base-case losses for an `AAA' rating and to cover three times the base-
case losses for an `A' rating (whether or not the Security is
subordinated).
Cash flow modeling is performed so that the minimum credit support
levels required on the Closing Date which, when combined with
structural features that trap Excess Spread, are sufficient to cover
losses at various levels. The cash flow modeling also allows the
liquidity of a proposed structure to be tested, using worst-case
scenarios regarding repossession, recovery periods and amounts,
prepayments and reinvestment rates for investment and cash on deposit.
The amount of scheduled principal payments available to retire these
Securities under various stress scenarios; e.g., higher than expected
prepayments, delinquencies and losses or less than expected Excess
Spread is also considered. In addition, the sufficiency of liquidity
(funds on deposit in reserve accounts) to pay the principal balances by
the legal final maturity date is examined.
A loss curve showing the timing of losses is then determined in
order to decide which types of credit support are necessary. For
example, auto loan loss curves are significantly front-loaded with peak
losses occurring between 6 to 18 months for most five-year collateral
pools. Credit is given to Excess Spread on a discounted, conservative
basis. The presence of triggers (see below), which raise the level of
the reserve account as a percentage of current outstanding Securities
or collateral if performance begins to deteriorate, is also given
credit. A conservative estimate of investment return on any cash held
pending distribution in reserve/spread accounts is made; e.g., 2.5%,
unless a guaranteed investment contract issued by an entity with a
rating at least equal to the desired transaction rating is used.
Greater credit support is required if there is insufficient
geographic loan distribution or disproportionate amounts in states
which are not economically diverse or which have onerous repossession
requirements. Greater credit support may also be required to address
liquidity risks as the rating addresses the likelihood of timely
payment of interest. The common liquidity risks addressed in motor
vehicle loan transactions include the following: early maturity,
differences in how borrowers are credited with having made interest and
principal payments under the terms of the loan and how interest and
principal are paid to securityholders. Interest rate risk where the
motor vehicle loans are fixed rate but the Securities have a variable
interest rate is also considered.
In auto transactions which feature declining credit support
requirements over the life of the transaction, credit support floor
coverage, which provides a minimum percentage of credit support at the
end of a securitization, may be required. This is because even though
most losses occur between 6-18 months and borrowers are less likely to
default once they have built up equity, losses may increase as a
transaction enters its final stages. In general, for an ``AAA'' rated
auto transaction, a reserve account floor is required when the pool has
amortized down to 20% of its original total balance. Auto loan
securitizations may use overcollateralization and subordination as
credit support.
Excess spread in automobile transactions usually ranges between 2%-
3% for prime issues and 7%-14% for subprime issues and can be used to
absorb credit losses and/or to build up reserve/spread accounts or to
create overcollateralization. Spread and reserve accounts protect
against disruptions in cash flows for delinquencies and payment
disruptions (e.g., bankruptcy of the Sponsor/Servicer). The amount of
cash available in these accounts is a very important rating
consideration. However, a reserve or spread account which is funded on
the Closing Date is more favorably regarded than Excess Spread. This is
because if the amounts are set aside on the Closing Date, they are
immediately available; whereas, if they are to be funded over time from
projected Excess Spread, their availability is less certain.
Accordingly, if losses are projected such that credit support equaling
8% of the transaction were to be required, the entire 8% could not be
provided solely through Excess Spread.
[[Page 51479]]
Automobile securitizations often feature credit support triggers,
which allow initial credit enhancement levels to be maintained until
certain levels of pool loan delinquencies or losses occur, at which
point higher credit enhancement levels are ``triggered.'' If the
performance of the securitized pool of loans deteriorates beyond the
specified levels, the cash flow mechanics of the transaction will
divert the flow of funds (typically Excess Spread is captured to
enhance the spread account to a particular level) to provide additional
protection for the Securities. Conversely, because the quality of an
auto loan pool increases over time, credit support levels are generally
permitted to decline proportionately as a tranche amortizes, provided
that losses and delinquencies are within expectations. However, once
delinquency and loss triggers are reached, the dollar amount of credit
support either stops declining or increases to a higher specified
level, in both cases by retaining some or all Excess Spread. The
effectiveness of the triggers and the incremental amount of Excess
Spread that must be retained as performance deteriorates are
considered, as is the timing of the trigger being reached.
2. Residential/Home Equity Mortgage Transactions
The Applicant provided the following information on typical
transactions. In a typical residential mortgage transaction, ``AAA''
rated senior Securities might be issued which represent approximately
95% of the principal balances of the Securities; ``AA'' rated
subordinated Securities might comprise 2%; ``A'' rated subordinated 1%;
``BBB'' rated subordinated 1% and junior subordinated Securities might
constitute 1%. The total level of credit enhancement from all sources
averages about 4% in order to obtain ``AAA'' rated Securities, 2% for
an ``AA'' rating, 1.5% for an ``A'' rating and 1% for a ``BBB'' rating.
Subordination is the predominant type of credit support used in
traditional residential mortgage transactions.
In a typical ``B&C home/equity loan'' transaction (see description
below), ``AAA'' rated senior Securities might be issued which represent
80% of the principal balances of the Securities; ``AA'' rated
subordinated Securities might comprise 11%; ``A'' rated subordinated
6%; ``BBB'' or lower rated subordinated Securities might constitute 3%.
The total level of credit enhancement from all sources averages about
13% in order to obtain ``AAA'' rated Securities, 10% for an ``AA''
rating, 7% for an ``A'' rating and 3% for a ``BBB'' rating.
In a typical high LTV ratio (i.e., above 100%) second-lien loan
transaction, ``AAA'' rated senior Securities might be issued which
represent approximately 76% of the principal balances of the
Securities; ``AA'' rated subordinated Securities might comprise 10%;
``A'' rated subordinated 3%; ``BBB'' rated subordinated 4% and junior
subordinated Securities might constitute 7%. The total level of credit
enhancement from all sources averages about 24% in order to obtain
``AAA'' rated Securities, 14% for an ``AA'' rating, 10% for an ``A''
rating and 7% for a ``BBB'' rating.
Typical types of credit support used in home equity transactions
are subordination, reserve accounts, Excess Spread,
overcollateralization and in transactions which do not use
subordination, financial guarantees from ``AAA'' rated monoline
insurance companies or highly rated Sponsors. The Applicant provided
the following description of the analysis performed by the Rating
Agencies in their consideration of residential/home equity
securitizations and their determination of appropriate credit support
requirements.
(a) Residential/Home Equity--General Considerations--The non-
commercial mortgage securitization market can generally be divided into
two basic types of assets: ``residential mortgages,'' the majority of
whose Obligors have ``prime'' credit ratings, and all other
securitizations of residential real estate which are collectively
referred to as ``sub-prime'' or ``home equity'' loans (manufactured
housing is treated as a separate type of asset and is discussed below).
The term ``home equity'' loan includes second mortgages taken out to
finance home improvements as well as first and second-lien loans where
the purpose of the loan is either for refinancing an existing loan, a
source of credit in lieu of using credit cards or for debt
consolidation. In addition, it includes first-lien and second-lien
loans used to purchase a residence where the borrower does not have an
A credit rating.
The dollar volume of home equity loan Securities is now the largest
segment of the securitization market, surpassing credit cards. The
primary reason for this is that borrowers are increasingly turning to
first and second-lien home equity loans instead of other forms of
consumer borrowing (i.e., credit cards), as the interest rates on the
loans are lower, and the interest payments may be tax deductible. These
types of loans have a higher credit risk than traditional first-lien
mortgages. However, the Rating Agencies adjust for the additional risk
by requiring additional credit support for each tranche of Securities
in order to achieve the same rating as would be given to a comparably
rated tranche in a residential mortgage securitization.
Another significant feature of home equity loans is that they may
have higher LTV ratios than residential mortgages, often higher than
100%. In transactions where LTV ratios are in excess of 100%, little or
no credit is given to the collateral in determining necessary credit
support, which instead must be supplied from other sources. In the
traditional rating analysis for residential mortgage securitizations,
the single most significant factor historically was the loan-to-value
ratios of the mortgages in the pool. However, statistical information
has clearly shown that LTV's on both residential and home equity
mortgages are much less important as a predictor of risk than the
quality of the borrowers and their capacity to make loan payments. This
is due to a borrower's reluctance to default on his residence, without
regard to the amount of equity that is built up. There is an increased
ability to assess borrower credit risk through the use of credit/
mortgage scoring systems. In order for an originator's credit scoring
system to be incorporated into the rating process, however, the system
is tested against a blind pool of loans with known default rates to
verify the validity of the scoring system to predict losses. Capacity
to pay is indicated by the borrower's monthly debt-to-income ratio. The
Rating Agencies test the predictability of such scoring systems before
relying upon them in their credit analysis.
Home equity loans can be subdivided into different categories. The
first category, known as ``B & C home equity loans,'' are made
primarily to B & C quality borrowers for consolidating credit card and
other consumer debt or refinancing existing mortgage loans. The second
category, known as ``home equity lines'' of credit,\34\ are usually
made to A quality buyers for large specific purchases, such as a car or
their children's college education expenses. The third category, known
as home improvement loans, include loans which are guaranteed by
governmental
[[Page 51480]]
agencies such as the U.S. Department of Housing and Urban Development
(``HUD'') but have borrowers with poor credit quality (below B & C) or
are non-guaranteed home improvement loans with B & C credit borrowers.
The fourth category refers to high LTV ratio loans with borrowers of
mixed credit quality but on average above B & C quality.
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\ 34\ While this group of transactions may include pools where
some portion of the mortgages may be substituted throughout the life
of the transaction to provide additional credit support,
substitution is currently permitted under the Underwriter Exemptions
only for defects in documentation. The Underwriter is not requesting
relief for transactions with this feature.
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In transactions where the credit quality of the borrower is lower
and LTV ratios are higher, the interest rates charged on the loans are
significantly greater than those on traditional residential loans. This
results in Excess Spread of typically 450-550 bps which can be used as
credit support. The home equity market has had a sufficient track
record to provide the Rating Agencies with a depth of expertise and
statistical information to rate these Securities with a high degree of
reliability. The Securities have been well received by investors as
they have tended to offer higher returns than comparably rated
residential mortgage Securities in all rating categories other than
`AAA.' In addition, although the prepayment rates are higher for home/
equity Securities than for traditional residential Securities, these
prepayment rates are more constant and thus more predictable.
(b) Residential/Home Equity--Determination of Expected Losses and
Amount of Credit Support--The basic approach used by all of the Rating
Agencies to determine the level of credit support necessary for each
tranche of a residential/home equity securitization is similar.
Historical data is used to predict loss frequency and severity of loss
in arriving at the necessary amount of credit support for each rating
level. Essentially, the process may be described as follows.
The appropriate credit enhancement for a residential/home equity
Security is determined by evaluating the individual characteristics of
the mortgages supporting the Security, the aggregate characteristics of
the mortgages considered as a pool and the structure of the Securities
offered. The model identifies the characteristics of the mortgage that
contribute to the likelihood of default and loss (i.e., loss frequency)
and the size of the mortgage loss in the event of default (i.e., the
loss severity). Among the characteristics examined are the LTV ratio of
the mortgage, the type and term of the mortgage, the type of mortgaged
property, the guidelines used in approving the mortgage and the quality
of the borrower. The credit enhancement required for a mortgage is
calculated by multiplying the loss frequency for the mortgage by its
loss severity. In assessing potential severity, the calculated severity
is compared to a minimum loss percentage, using the larger of the two
figures to calculate the credit enhancement for the mortgage.
The sum of the credit enhancements for the individual mortgages
represents the initial credit enhancement requirement for the mortgage
pool. This figure is then adjusted for mortgage pool characteristics
and for originator and Servicer quality. Pool characteristics,
including the number of mortgages and the geographic concentration of
the mortgaged properties, are important because they impact the
statistical independence of the mortgage level credit enhancement
calculations. The originator adjustment reflects an assessment of the
originator's ability to generate mortgages that perform better or worse
than otherwise similar mortgages. The Servicer adjustment reflects an
assessment of the Servicer's ability to keep mortgagors paying and to
mitigate losses in the event of default. The credit enhancement
requirement established after these adjustments reflects a full
assessment of the credit risk of the entire mortgage pool. Additional
adjustments may be necessary in response to structural aspects of the
transaction. Among the transaction characteristics that can have a
significant impact on credit enhancement levels are the sequence of
payments among different classes of Securities, the allocation of
mortgage principal prepayments, the form of credit enhancement and its
provider and the relative size of the classes offered. An analysis of
the cash flow necessary to make timely payments of principal and
interest is performed, and the last step in determining the amount of
credit support necessary for each rated Securities tranche is to test
the ability of a pool of mortgages to withstand certain stress tests
and still be able to generate timely payments of interest and pay
principal on or before maturity.
In developing a stress model, conservative assumptions are made as
to real estate market conditions, economic factors and expenses
associated with events of loss, applying a worst-case scenario
incorporating high unemployment, deflation and sharply falling real
estate values. The worst-case model considered by S&P to be appropriate
for its highest rating categories incorporates the foreclosure
frequencies and loss severity experienced during the Great Depression
of the 1930s, whereas other Rating Agencies use those experienced in
the Houston, Texas disastrous housing market in the mid-1980s. The
choice of economic model is selected based on the severity of the
stress to be applied. Generally, ``AAA'' and ``AA'' rated Securities
have to withstand so-called national depression models based on the
Great Depression/Houston, Texas models. For ``A'' and ``BBB'' rating
categories, other geographic severe depression models, such as Boston
in the 1980s or New York and Los Angeles in the early 1990s, might be
used as the basis for the stress model. Alternatively, a system of
local forecasting models or some other statistically derived stress
models may be created for these purposes. ``BB'' rated Securities or
lower would have to withstand less severe recession models.
The initial frequency and severity of loss analysis on each
mortgage in the pool may be described as follows. A computer model is
used to analyze the expected losses on a mortgage pool backing
Securities. The model examines (i) characteristics of each underlying
mortgage to determine the probability of it defaulting and (ii) the
default performance of several million mortgages originated or serviced
by established originators. A housing price index may be used which
combines housing price and other economic data and refines the analysis
to the smallest geographic unit for which reliable information can be
found (usually a metropolitan statistical area). This approach enables
the Rating Agencies to analyze variations in losses arising from
differences in real estate markets with separate housing price
histories, regional economic conditions and foreclosure experience.
Through an analysis of adverse economic conditions for discrete
geographic areas, the localized impact of regional business cycles and
economic restructuring can be factored into the process.
Mortgages in a pool must have certain preferred characteristics to
qualify as prime mortgages. In the absence of other mitigating factors,
additional loss coverage will be required for pools failing to meet
prime pool criteria. The following are the basic criteria for mortgages
in a prime pool: first liens on single-family detached properties
located in the United States; fixed-rate loans; level payment, fully
amortizing loans on the mortgagor's primary residence; mortgages not in
excess of a dollar-ceiling amount; a loan-to-value ratio of 80% or
less; mortgage documentation and underwriting consistent with Fannie
Mae/Freddie Mac guidelines, including minimum underwriting criteria of
a fixed percent ratio of borrower's monthly housing expense (e.g., 28%)
to gross monthly income and a fixed ratio of borrower's
[[Page 51481]]
total monthly debt obligations to gross monthly income (e.g., 36%);
whether properties securing mortgages in the pool are well dispersed
throughout an area having a strong and diversified economic base and
whether there is a minimum number of loans in the pool (e.g., 300).
Because most mortgage loan pools do not meet prime pool criteria in
each category, rating a portfolio involves assessing the additional
credit enhancement required owing to the deviation from prime pool
criteria.
Other factors may have a bearing on default rates and could
counterbalance negative characteristics of a pool. Thus, a portfolio of
well-seasoned mortgage loans would be expected to experience a lower
default rate than newly originated loans due to both the history of the
creditworthiness of the borrowers and the lower loan-to-value ratio
associated with seasoned loans. (For example, default rates are highest
in the 3-8 year period of a loan.) The marketability of the underlying
mortgages is also an important factor in determining required loss
coverage because collateral underlying a defaulted loan needs to be
liquidated as quickly as possible. Another significant factor is the
availability and type of insurance in connection with the pooled
mortgages and their underlying properties. Mortgage insurance, hazard
insurance, special hazard insurance, pool insurance on the underlying
properties and bankruptcy insurance covering mortgagor bankruptcy and
insolvency all may be relevant to the rating of the Security. Primary
mortgage insurance (PMI) also can reduce the loss coverage required on
a mortgage pool. The credit of the PMI issuer and the quality of its
underwriting standards are considered by the Rating Agencies. However,
the full benefit of a reduced loss coverage requirement will be
available only if the PMI issuer meets Rating Agency standards.
The rating of a residential mortgage loan pool will also vary
depending upon the purpose for which the mortgage loans have been made.
The most desirable loan is a purchase money mortgage loan for the
financing of the mortgagor's single-family detached primary residence.
In contrast, home equity loans and apartments, condos, coops, non-owner
occupied or vacation homes are projected to have higher losses. The
type of loan is also considered. For example, adjustable rate, balloon
payment and negative amortization of principal features are all
negative factors. The loss severity analysis assumes that the potential
for loss upon foreclosure of a second mortgage is greater than for loss
upon foreclosure of a comparable first mortgage. The foreclosure
frequency analysis for second mortgage loans focuses on the increased
credit risk generally associated with second mortgage loans, which
frequently are not subject to standard underwriting criteria based upon
Fannie Mae and Freddie Mac standards and generally have lower combined
LTV ratios than is the case for first mortgages. Geographic
diversification of the properties securing mortgages in the pool is
important to spread the risk of loss, and higher loss coverage is
required for pools of fewer than 300 loans.
As many insurable risks as possible are reduced or eliminated,
which is generally accomplished by requiring various types of insurance
or bonding expressly covering such risks. Because costs of insurance
premiums are in some cases prohibitive, Issuers over the years have
devised alternative forms of credit enhancement to avoid the purchase
of third-party insurance. Frequent substitutes include lines of credit
from large commercial banks, self insurance (available only to Issuers
with high credit ratings) and overcollateralization. Hazard insurance
must be in place with respect to all properties securing the mortgages
that constitute the pool.
(c) Residential/Home Equity--Selecting the Type of Credit Support--
The most prevalent forms of credit support for residential/home equity
Securities are the senior/subordinated tranched structure,
overcollateralization, Excess Spread, reserve funds and surety bonds.
In addition, as described above, pool insurance may be obtained for
credit losses on the mortgages.
3. Manufactured Housing Transactions
The Applicant states that, in a typical manufactured housing
transaction, ``AAA'' rated senior Securities might be issued which
represent approximately 80% of the principal balances of the
Securities; ``AA'' rated subordinated Securities might comprise 6%;
``A'' rated subordinated 5%; ``BBB'' rated subordinated 5% and junior
subordinated Securities might constitute 4%. The total level of credit
enhancement from all sources including Excess Spread averages about
15%-16% in order to obtain ``AAA'' rated Securities, 10%-11% for an
``AA'' rating, 7.5%-8.5% for an ``A'' rating and 3.5%-9% for a ``BBB''
rating. Typical types of credit support used in manufactured housing
transactions are subordination, reserve accounts, Excess Spread,
overcollateralization and financial guarantees from ``AAA'' rated
monoline insurance companies or highly rated Sponsors. The Applicant
provided the following description of the analysis performed by the
Rating Agencies in their consideration of manufactured housing
securitizations and their determination of appropriate credit support
requirements.
(a) Manufactured Housing--General Considerations--There has been a
general growth in the sale of manufactured housing and an improvement
in the construction of the units. Transactions with a greater
percentage of multi-wide units, customized units and units financed
with land privately purchased (as opposed to being placed in trailer
park rental spaces) are being securitized which results in less loss
severity, as such units have greater resale value, and these types of
units are increasingly being purchased by owners with better credit
histories. There has also been an increased public market for
manufactured housing-backed Securities since the 1980s due to a trend
toward lower repossessions and lower losses on such mortgages as a
result of improved underwriting and servicing throughout the industry,
strong investor interest in medium-term structured investments with
loan terms typically between 15-20 years (versus 5 for autos and 30 for
residential mortgages) and the inclusion of manufactured housing
contracts as qualifying assets for REMICs, which facilitates the
issuance of multi-class Securities.
(b) Manufactured Housing--Determination of Expected Losses--LTV
ratios are not considered as significant a factor in predicting loss
frequency in manufactured housing securitizations as they are for
conventional home mortgages because the loan amounts are lower and
significant equity is not built up. Instead, the Rating Agencies assign
a frequency of default and loss severity factor to the pool of loans
(in some cases, on a loan-by-loan basis) to project losses.
An analysis of the credit quality of the underlying pool of
manufactured housing contracts in a particular securitization
transaction is performed by developing static pool data based on the
historical performance of the specific originator of the contracts.
This information (which is continuously updated) is then used to
predict expected cumulative net losses for the particular pool which
takes into account both foreclosure frequency and loss severity. The
historical data is adjusted depending on the Servicer's capacity to
service the loans, the type of collateral being financed, LTV ratios,
loan seasoning, underwriting of loan
[[Page 51482]]
standards, experience of management and the quality and quantity of the
historical information provided by the originator. As a result, the
expected cumulative losses will vary from originator to originator.
An analysis of the actual pool is also performed to predict loss
frequency based on collateral characteristics such as type of unit
(single versus multi-wide) and real property type (trailer park,
private rental or private owned) and loan attributes such as whether
the LTV ratios, loan interest rates, loan terms and monthly payments
are high (which is a negative factor) and how long the loan has been
outstanding (as the risk of default is higher in the earlier years of
the loan). Also considered are borrower demographics. The elements
regarding borrower demographics which have the greatest impact on
default frequency are the originator's borrowing credit scoring
methodology, debt-to-income ratios, purchase versus refinance status,
employment period, employment status, borrower's age, existing versus
first-time home buyer and presence of a co-signer. The specific impact
of geographic distribution is forecasted using a mortgage default model
which divides the United States in a myriad of counties, standard
metropolitan statistical loan areas and state and multi-state regions.
This model is used to forecast foreclosure rates and home price trends
by projecting economic conditions over a fixed number of years.
Loss severity is determined by predicting the expected recovery
rate in case of loan default (i.e., the percentage of the outstanding
balance realized upon liquidation of the unit). For example, recovery
rates are high (typically 70%) during the first two years after
origination and thereafter drop to a lower constant level. The most
significant factors affecting loss severity are the age of the unit and
the delay time in repossessing and recovering on the unit. Here LTV
ratios are a significant indicator of loss severity as repossession
costs are usually fixed and, therefore, the lower the net equity the
lower the percentage recovery. Also, whether the originator/Servicer
has good access to retail distribution for repossessed units
significantly affects recoveries. Dealer/manufacturer recourse is also
a very important factor in determining both frequency and severity of
loss expectancies. Some originators have recourse programs under which
dealers or manufacturers will repurchase a defaulted contract at the
time of default or cover any loss associated with liquidation of the
repossessed unit. The recourse obligation can vary from six months to
five years. The amount of credit given to dealer recourse is affected
by whether the dealers have historically honored their recourse
commitments. The use of dealer recourse is also scrutinized to
determine whether a repossession is treated as a default, and if dealer
recourse is applicable, to make sure that the originator is not
understating its default rates.
(c) Manufactured Housing--Determining Required Amount of Credit
Support--In order to determine how much credit support is required, a
determination is made as to how much principal liquidation losses can
be covered by Excess Spread collection, as opposed to other credit
support. Through various cash flow tests, an amount of credit support
is calculated that, when combined with Excess Spread, is sufficient to
cover all losses under the various rating stress scenarios, while still
paying timely interest and principal by the final maturity date for all
tranches of Securities issued. Various cash flow runs are reviewed
assuming multiples of expected repossession, losses and prepayments to
value the amount of Excess Spread that would be generated over the life
of the transaction. In a typical manufactured housing securitization,
the cumulative net losses on the pool of loans are expected to
represent approximately 6%-8% of the original pool balance. Various
minimum standards for cash flows at each rating category level are then
fixed. For example, in order to merit an ``AAA'' rating, the Rating
Agency might require the cash flows sufficient to pay all interest and
principal while withstanding a 44% cumulative default frequency, a
recovery of 37% (assuming a recovery time lag of six months) and 28% in
cumulative net losses. For a ``BBB'' rated tranche, cash flows might be
required to withstand a 28% cumulative default frequency, a recovery
upon default of 50% and 44% in cumulative losses. The originator's
expected loss curve, i.e., how soon defaults occur in the life of the
securitization are factored into the cash flow runs, which are then
subjected to additional stress (e.g., if the originator's expected loss
curve is such that 65% of all anticipated defaults will occur by year
five after origination, the Rating Agency will assume 75% will occur in
this time period). Finally, if such information is available,
prepayments are presumed to occur first on the highest coupon-bearing
loans, which maximizes the stress put on the cash flow runs. The final
credit support is determined by setting the final loss coverage level
required which represents some multiple of the cumulative credit losses
expected over the life of the transaction.
At the time the original Underwriter Exemptions were requested,
manufactured housing securitizations were structured to offer only
``AAA'' rated senior Securities using third-party letters of credit
(LOC) as security, with spread accounts and Issuer recourse protecting
the LOC. However, since that time, such transactions are typically
structured using a senior/subordinated structure. All subordinated
Securities which receive ``A'' or ``BBB'' ratings themselves have other
forms of credit support. A typical transaction would have a large
percentage of subordinated classes, representing 20% of the principal
balances of the Securities, and such subordinated classes could range
from ``AA'' to ``B'' rated tranches. These subordinated Securities have
longer lives than the single tranche senior-only securitization
transactions structured with credit support solely from third-party LOC
and spread accounts.
Overcollateralization is also used as credit support for the
subordinated Securities once the seniors have been paid. Because the
coupon rate on manufactured housing loans is substantially higher than
that charged on traditional residential mortgages, there is a large
amount of Excess Spread (typically more than 300 bps) that can be used
for credit support of both senior and subordinated tranches. In other
structures, the Excess Spread is trapped into a reserve fund which
provides the credit support for the subordinated tranches. In still
other cases, credit support is provided to an investment-grade
subordinated tranche through a junior subordinated tranche which
receives principal only after the more senior subordinated tranches are
paid. Sponsor guarantees are also used as credit support.
4. Commercial Mortgage-Backed Securities (CMBS)
The Applicant states that in a typical CMBS transaction, two
classes of ``AAA'' rated Securities might be issued which represent
approximately 78% of the principal balances of the Securities (one such
``AAA'' class will be issued with a shorter, and the other ``AAA''
class with a longer, expected maturity); ``AA'' rated subordinated
Securities might represent 5%; ``A'' rated subordinated 5%; ``BBB''
rated subordinated 5% and junior subordinated Securities 7%. The total
level of credit enhancement from all sources averages about 23% in
order to
[[Page 51483]]
obtain ``AAA'' rated Securities, 18% for an ``AA'' rating, 13% for an
``A'' rating and 7% for a ``BBB'' rating. Subordination is generally
the only type of credit support used in CMBS transactions. The
Applicant provided the following description of the analysis performed
by the Rating Agencies in their consideration of CMBS securitizations
and their determination of appropriate credit support requirements.
(a) CMBS--General Considerations--CMBS transactions securitize
pools of commercial mortgage loans which generally represent a mix of
asset types, principally retail, multi-family, office, hotel/motel and
industrial. While most CMBS transactions have pools with multiple
Obligors on the loans, the term also includes securitizations which are
``property specific'' and represent either a single or small number of
high-quality properties with respect to which there is one Obligor.
While property specific CMBS securitizations do not represent a pool of
mortgages with different Obligors, the LTV ratios are much lower, and
the credit quality of the single Obligor is much higher, than would be
the case in a CMBS securitization of a pool of assets. In property
specific CMBS transactions, Securities are generally not issued with a
rating lower than ``BBB'' which is an indication of the superior credit
quality of the Obligors. Another category of CMBS transactions is the
credit (or net) lease transaction where a loan is made to the ground
lessor of the real estate and the securitization rating is based on the
credit quality of the underlying lessee instead of the lessor/Obligor
on the note. In a net lease transaction, the obligor on the note which
is being securitized is the lessor of the property, and the lessee of
the property is the party actually involved in the management of the
property.\35\ Accordingly, the true source of payment on the note is
the cash flow generated by the lease payments. As a result, the ratings
agencies look to the credit quality of the lessee and not that of the
lessor/note obligor. However, the rating process for all three types of
CMBS transactions is generally similar.
(b) CMBS--Due Diligence--Due diligence for CMBS is performed by
multiple parties, at multiple levels. Every CMBS pool is sampled and
analyzed by the originator, the Rating Agencies, the Underwriter and
the purchasers of subordinated classes. Every mortgage pool is sampled
for underwriting and site inspection due diligence. A representative
sample of the collateral by loan size, geographic location, property
type, originator and other common features is reviewed in conjunction
with the assets that pose the largest risks to the transaction, such as
loans with the largest balance or related borrowers. The asset
summaries and files are reviewed to assure that the sample selection is
representative of the pool. If the initial sample is insufficient,
further sampling will be required until the Rating Agency is
comfortable extrapolating the findings to the remainder of the pool. In
property specific transactions, due diligence is performed for each
property. Site inspections and file reviews are performed to determine
the quality of the real estate and the integrity of the asset files. A
quality grade may be assigned to each visited property. The quality
grade will reflect the property location, condition, tenancy,
management, amenities, competitive market position and other relevant
information that may affect the underwriting of the asset. Asset
summaries and loan files are reviewed to obtain more detailed
information about pool assets and the quality of the underwriting.
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\35\ In the case where the landlord owns the land and retains
ownership of the building, the lessor would be both the ground
lessor and the building lessor. In other cases, where the tenant
owns the building, the landlord would be only the ground lessor. The
obligation held by the Issuer would be secured by either the ground
lease or the real estate.
---------------------------------------------------------------------------
The originator's mortgage loan systems are examined, as well as
their actual execution through meetings with management and extensive
file reviews. The number of years of the originator's real estate
experience, whether it escrows taxes and insurance, whether it is able
to provide several years of operating statements verified by source
documents and whether there is recourse to a third party in case of
fraud are considered. Audit checks and legal searches may also be
performed on the originators.
The Servicer function in a CMBS transaction is particularly
important because not only does the Servicer or Servicers fulfill the
normal functions of collecting and remitting loan payments from
borrowers to securityholders and advancing funds for such purposes, but
the Servicer may also become responsible for activities relating to
defaulted or potentially defaulting loans (which are more likely to be
restructured than in non-commercial transactions where the loans are
usually liquidated). If a Servicer advances funds, its credit rating
cannot be more than one rating category below the highest rated tranche
in the securitization and no less than ``BBB'' unless it has a
qualifying back-up advancer. All entities servicing CMBS transactions
must be approved by the Rating Agencies.
An additional responsibility of the Servicer is ensuring that
insurance is maintained by each borrower covering each mortgaged
property in accordance with the applicable mortgage documents.
Insurance coverage typically includes, at a minimum, fire and casualty,
general liability and rental interruption insurance but may include
flood and earthquake coverage depending on the location of a particular
mortgaged property. If a borrower fails to maintain the required
insurance coverage or the mortgaged property defaults and becomes an
asset of the Issuer, the Servicer is obligated to obtain insurance
which, in pool transactions, may be provided by a blanket policy
covering all pool properties. Generally, the blanket policy must be
provided by an insurance provider with a rating of at least ``BBB.''
Each Servicer, special Servicer and Subservicer is required to
maintain a fidelity bond and a policy of insurance covering loss
occasioned by the errors and omissions of its officers and employees in
connection with its servicing obligations unless the Rating Agency
allows self-insurance. All fidelity bonds and policies of errors and
omissions insurance must be issued in favor of the Trustee or the
Issuer by insurance carriers which are rated by the Rating Agency with
a claims-paying ability rating no lower than two categories below the
highest rated Securities in the transaction but no less than ``BBB.''
Subservicers may not make important servicing decisions (such as
modifications of the mortgage loans or the decision to foreclose)
without the involvement of the Master Servicer or special Servicer, and
the Trustee or any successor Servicer may be permitted to terminate the
subservicing agreement without cause and without cost or further
obligation to the Issuer or the holders of the rated Securities.
Loans secured by credit tenant leases require special analysis.
Credit enhancement for credit tenant loans is based on an analysis of
the probability that the lessee will file bankruptcy, and the
likelihood that the lessee will disaffirm the lease and loan structures
that may present a risk other than that of the lessee filing
bankruptcy.
(c) CMBS--Determination of Expected Losses and Required Credit
Support--The approach to rating CMBS transactions is not that different
from other asset types, as it is based on the concept of estimating
default frequency and loss severity for the loans being securitized,
applying adjustments for
[[Page 51484]]
various factors relating to the pool as a whole and stressing the pool
projected performance at various levels to determine the credit support
necessary for particular rating categories. However, the methodology
differs from that used for other asset types because the payments on
the loans are being made from the cash flow from the property's
operations and not a borrower's personal funds. Accordingly, the focus
of the rating process is on the ability of each property in the pool to
generate sufficient net operating income to comfortably carry the debt
service on a loan and to project the value of the business operation
based on capitalization of such projected income. This allows the
Rating Agencies to predict both default frequency and loss severity in
case of a borrower defaulting on a loan and is accomplished by an in-
depth evaluation of the properties that are being sampled in order to
essentially ``reunderwrite'' the loans in the pool. An analysis is done
to determine the ``debt service coverage ratio'' (DSCR) for each loan
which is similar in concept to the due diligence performed by the
original lender on the loan in deciding whether to make the loan and in
what amount. However, the estimates given by the borrower are not used
other than for informational purposes. Instead, the numbers are
reconfigured by increasing projected expenses and decreasing projected
income to take into account various contingencies using a worst-case
scenario. The Rating Agencies differ somewhat in how they perform these
calculations, but the analysis is intended to predict loss frequency
and loss severity in order to make informed decisions about the credit
support they will require at the different rating levels.
For example, the basic approach used by S&P to rate CMBS is to
analyze the cash flow generated by each loan, the loan's DSCR based on
stabilized net cash flow and its LTV ratio based on estimated property
values, which value is determined by capitalization of the net cash
flow generated by the property. These analyses are then used to
determine whether that loan is likely to default under various stress
scenarios, and if so, what the loss of principal might be. Further
adjustments are made for a presumed percentage decline in the value of
the property upon default and a lag time with an accompanying loss of
income before the defaulted loan is actually liquidated. Each stress
scenario is related to a particular rating category, so the aggregate
estimated losses of all loans in the pool under a given scenario
determine the amount of credit support required at each rating
category. A matrix model is used to generate estimated losses under a
variety of default scenarios which assume that the mortgage loans have
a 100% probability of defaulting at specific DSCR and LTV thresholds
and that the thresholds vary by property type and rating category. For
example, in an ``AAA'' rating category, all multi-family loans with a
DSCR below 1.65 and LTV ratios above 50% are presumed to default, and
for a ``BBB'' rating, all such loans with DSCR below 1.30 and LTV
ratios above 70% will default.
Fitch has a somewhat different approach to rating CMBS
transactions. The Fitch performing loan model is based on research
indicating that DSCR is the best indicator of loan default and that a
loan with a high DSCR is less likely to default than a loan with a DSCR
below 1.00. The modeling analysis is performed by calculating each DSCR
assuming an ``A'' stress environment. After reunderwriting asset cash
flows and stressing debt service, the DSCR is calculated. Based on the
stressed DSCR, a default probability and loss severity is assigned. The
expected loss on each loan is its percentage of the pool times its
default probability times its loss severity. The default probability
and loss severity assumptions based on the DSCR for each loan are then
adjusted based on certain property and loan features to determine the
necessary credit enhancement based on the individual loan
characteristics. Next, the composition of the pool is analyzed to
identify any concentration risks. Finally, the transaction structure is
evaluated and incorporated into the ratings. The results are further
adjusted to reflect various stresses from ``AAA'' to ``B.'' The final
credit enhancement levels for a transaction equal the sum of the loan-
by-loan expected losses based on the DSCR analysis plus or minus
adjustments for particular asset characteristics, pool concentration
issues and structural requirements.
Factors that are considered in determining cash flows are extensive
and may differ among Rating Agencies but could include the following
items. Management's budget for the property for the next year is
reviewed taking into consideration economic and demographic information
about the market in which a property is located. Trends in population
growth, household formation and composition, employment, income,
existing competition, the vacancy rate, trends in building permits and
proposed construction are examined. In arriving at a stabilized income
figure for all types of commercial properties, rents are adjusted to
reflect market rates, and any seasonal changes in the income stream are
factored into the analysis. Gross potential rental income and income
from other sources are reduced by vacancy and collection losses.
Assumptions based on property type of combined vacancy and credit
losses are made, even if the historical vacancy and credit loss has
been lower. All normal expenses for the property are accounted for
whether currently incurred or not. If the property is subject to a
ground lease, ground rent must also be included in expenses. If the
ground rent payments increase significantly over time, the amount of
the payment is stabilized by taking an average or calculating a level
annual equivalent at an appropriate yield. Revenue is marked to the
lower of market or actual rent and occupancy. Consideration is given
for future conditions, such as new construction, that could affect
rents and/or occupancy. Reserves are taken for normalized tenant
improvement, leasing commissions and capital repair and maintenance.
Care is taken to incorporate all material facts with respect to the
property, such as lease rollover risk, credit tenants, ground lease
payments, recent capital improvements, market conditions and collateral
quality.
Debt service analysis estimates debt service payments required in
the event a loan must be refinanced under a stress environment. A
specific interest rate and amortization terms based on property types
is assumed to determine a hypothetical constant payment rate. The
refinance rate is not based on the prevailing interest rate or the
highest historical rate but, rather, on rates generally available over
a fixed period of years using a designated environment. For fixed-rate
loans, the interest rate is reduced by a specified number of basis
points if the loan is fully amortizing over its term, and the actual
interest rate (the greater of pay or accrual rate) is used if it is
higher than the assumed interest rate. Because floating-rate loans may
be affected by rising interest rates, the lesser of the ceiling rate,
if any, and a stress rate is used for floating-rate loans. In a pool
transaction, each borrower may or may not be required to fund a
replacement reserve for capital expenditures, depending on the practice
of the loan originator. Regardless of whether replacement reserves are
required, it is assumed that each borrower in a pool will find it
necessary to make some amount of capital expenditures each year to
preserve the value of its investment. Third-party appraisals of the
underlying real estate assets are
[[Page 51485]]
considered, but they generally use such reports only for the
information that they contain regarding conditions in local markets
rather than for their specific property value conclusions.
Estimates of loss frequency and loss severity are further adjusted
for the following types of qualitative factors: certain types of
property will tend to lose tenants in economic stress periods (e.g.,
hotels and restaurants) and will have more volatile cash flows (e.g.,
seasonal industries); environmental risks, such as asbestos; climate
risks (e.g., earthquakes and floods) and economic trends (e.g., some
states are slow in paying nursing home reimbursements). Extensive
default regression analysis has also been performed to isolate which
asset types have higher default rates and higher loss severity
percentages. The more geographically diversified the loans are, the
lower the loss frequency. Loan size does not clearly correlate to loss
frequency so is it minimized as a factor, but loan size can affect
severity as the larger the loan the more severe its effect can be on
the pool as a whole. Fixed interest rate loans have lower default and
severity rates than floating, and the lower the interest rate, the
lower the default rate. Balloon mortgage loans have a higher rate of
default than amortizing loans. Loans with subordinated liens, loans
underwritten by lenders with non-typical underwriting standards and
loans characterized by prior defaults or workouts all require greater
credit support.
Environmental reports for each property are generally required. A
reserve is usually required for any reported remediation costs, and any
actions covenanted must be completed within a specified period. Risks
that cannot be quantified or that have not been mitigated through
either remediation or reserves are assumed to pose a risk to the Trust
and are reflected in the credit enhancement requirements. Properties
with certain types of asbestos problems, or those that are assumed to
have such problems given their date of construction, are assumed to
have higher losses due to the clean-up costs and increased difficulty
or cost in leasing or selling the asset. Seasoned or acquired pools
that may not have current reports for each property are also assumed to
have higher environmental losses.
(d) CMBS--Selecting the Type of Credit Support--In general,
although there are other types of credit support available,
subordination is the only type of credit support used in CMBS. However,
protection is also provided to subordinated classes through the concept
of a ``directing class'' which has evolved to give those holders of
rated subordinated Securities in the first loss position some control
over the servicing and realization on defaulted mortgage loans. In a
typical transaction, the Servicer might be required to obtain the
consent of the directing class before proceeding with any of the
following: any modification, consent or forgiveness of principal or
interest with respect to a defaulted mortgage loan; any proposed
foreclosure or acquisition of a mortgaged property by deed-in-lieu of
foreclosure; any proposed sale of a defaulted mortgage loan and any
decision to conduct environmental clean up or remediation. The
directing class might also have the right to remove a Servicer, with or
without cause, subject to the Rating Agency's confirmation that
appointment of the successor Servicer would not result in a
qualification, withdrawal or downgrade of the then-applicable rating
assigned to the rated Securities, compliance with the terms and
conditions of the Pooling and Servicing Agreement and payment by the
directing class of any and all termination or other fees relating to
such removal. Holders of CMBS enjoy additional protection, in that the
Master Servicer or Servicer occupies a first-loss position and usually
holds an equity stake in the offering, which gives it an incentive to
maximize recoveries on defaulted loans. The Master Servicer and
Servicer are in a first loss position because they hold the most
subordinated equity position interest(s) in the Issuer. Accordingly,
they absorb losses before any other classes of securityholders.
Additional cash flow stability is created through call protection
features on the commercial mortgages held in the Issuer. Call
protection prevents the borrowers from prepaying the mortgage loans
during a fixed ``lock-out period.'' In certain transactions, under the
terms of the mortgage agreement, the borrower is only allowed to prepay
the loan at the end of the lock-out period if it provides ``yield
maintenance'' \36\ whereby it is required to contribute a cash payment
derived from a formula which is calculated based on current interest
rates and is intended to offset the borrower's refinancing incentive.
This amount also effectively compensates the Issuer for the loss of
interest payable on the mortgage loan.
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\ 36\ The Applicant represents that the yield maintenance
provision in the mortgage agreement would meet the definition of a
``yield supplement agreement'' currently permitted under section
III.B.(3)(b) of the Underwriter Exemptions.
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Another mechanism, referred to as ``defeasance'', assures stability
of cash flow and operates as follows. If a borrower wishes to have the
mortgage lien released on the property (for example, where it is being
sold), the original obligation either remains an asset of the Issuer
and is assumed by a third party, or a new obligation with the same
outstanding principal balance, interest rate, periodic payment dates,
maturity date and default provisions is entered into with such third
party. The new obligation replicates the cash flows over the remaining
term of the original obligor's obligation. In either case, the property
or assets originally collateralizing the obligation are replaced by
collateral consisting of United States Treasury securities or any other
security guaranteed as to principal and interest by the United States,
or by a person controlled or supervised by and acting as an
instrumentality of the Government of the United States; for any of the
foregoing (Government Securities). Defeasance generally operates so
that, pursuant to an assumption and release or similar arrangement
valid under applicable state law, the original obligor is replaced with
a new obligor.
The new obligor is generally a bankruptcy-remote special purpose
entity (SPE), the assets of which consist of Government Securities. In
the defeasance of a mortgage loan held in a CMBS pool, a new entity
must be created (the SPE) which becomes the obligor on the mortgage
loan and holds the Government Securities being substituted for the
original collateral securing the mortgage loan. This newly formed
entity is required by the Rating Agencies to be an SPE in order to
assure that the owner of the securities to be pledged has no
liabilities or creditors other than the CMBS pool trustee, has no
assets or business other than the ownership of the Government
Securities and is not susceptible to substantive consolidation with the
original mortgage borrower in the event of the original mortgage
borrower's bankruptcy. Such an SPE is purely passive and does not
engage in any activities other than the ownership of securities.
Although there is no prescribed market requirement as to ownership of
the SPE, the securitization sponsor (e.g., the original mortgage
lender) is usually its owner, except that in certain circumstances the
original mortgage borrower may own the SPE for a variety of reasons;
e.g., to be entitled to any excess value of securities pledged as
collateral at maturity of the new defeasance note over the amount due
at such time. As a condition to
[[Page 51486]]
defeasance, all fees and expenses are paid at the substitution of the
Government Securities for the mortgage lien. Mechanically, the
Government Securities are transferred to a custodian which holds then
as collateral for the securitization trust. The payments on the
Government Securities are actually made directly to the Issuer so that
the SPE does not receive any payments or make any payments.
Whether the original mortgage obligation is replaced with a new
securitized obligation or the original obligation remains an asset of
the Issuer, is usually dictated by how the transaction is treated for
mortgage recording tax purposes under state law. Both call protection
and defeasance are intended to protect investors from the risk of
prepayments of the loans.
5. Corollary Effects of Requesting Relief for Subordinated and
Investment Grade-Securities.
The Applicant wishes to note that the extension of exemptive relief
to the Designated Transactions described in this Section V. has a
corollary effect on other provisions of the Underwriter Exemptions
which will be discussed here.
First, the current ``seasoning requirement'' contained in the last
paragraph of section III.B. of the text of the current Underwriter
Exemptions provides that Certificates which have been issued in other
pools containing the same asset types must have been rated in one of
the three highest generic rating categories for at least one year prior
to the plan's acquisition of securities pursuant to the Underwriter
Exemptions. The Applicant believes that it is consistent with the
extension of exemptive relief to Designated Transactions to have this
seasoning requirement expanded to cover securities issued in Designated
Transactions which have been rated in one of the highest four generic
rating categories.
Second, the current Underwriter Exemptions provide in footnote 9
that the term ``Trust'' includes a two-tier structure, provided that
the securities held by the second Trust are not subordinated to the
rights and interests evidenced by the first Trust. This restriction was
based on the premise that the Underwriter Exemptions did not afford
relief for any subordinated securities. The Applicant believes that it
would be appropriate and consistent with the relief requested in
Section I. of this application for this non-subordination restriction
to be removed where the securities of the first Trust are issued in
Designated Transactions, even if they are subordinated to other classes
of securities issued by the first Trust.
VI. Remaining Provisions
A. Disclosure
In connection with the original issuance of Securities, the
prospectus or private placement memorandum will be furnished to
investing plans. The prospectus or private placement memorandum will
contain information material to a fiduciary's decision to invest in the
Securities, including:
1. Information concerning the payment terms of the Securities, the
rating of the Securities, any material risk factors with respect to the
Securities and the fact that principal amounts left in the Pre-Funding
Account at the end of the Pre-Funding Period will be paid to
securityholders as a repayment of principal.
2. A description of the Issuer as a legal entity and a description
of how the Issuer was formed by the seller/Servicer or other Sponsor of
the transaction;
3. Identification of the independent Trustee;
4. A description of the receivables contained in the Issuer,
including the types of receivables, the diversification of the
receivables, their principal terms and their material legal aspects,
and a description of any Pre-Funding Account used or Capitalized
Interest Account used in connection with a Pre-Funding Account;
5. A description of the Sponsor and Servicer;
6. A description of the Pooling and Servicing Agreement, including
a description of the Sponsor's principal representations and warranties
as to the Issuer's assets, including the terms and conditions for
eligibility of any receivables transferred during the Pre-Funding
Period and the Trustee's remedy for any breach thereof; a description
of the procedures for collection of payments on receivables and for
making distributions to investors, and a description of the accounts
into which such payments are deposited and from which such
distributions are made; a description of permitted investments for any
Pre-Funding Account or Capitalized Interest Account; identification of
the servicing compensation and a description of any fees for credit
enhancement that are deducted from payments on receivables before
distributions are made to investors; a description of periodic
statements provided to the Trustee, and provided or made available to
investors by the Issuer; and a description of the events that
constitute events of default under the pooling and servicing contract
and a description of the Trustee's and the investors' remedies incident
thereto;
7. A description of the credit support;
8. A general discussion of the principal federal income tax
consequences of the purchase, ownership and disposition of the
Securities by a typical investor;
9. A description of the Underwriter's plan for distributing the
Securities to investors;
10. Information about the scope and nature of the secondary market,
if any, for the Securities; and
11. A statement as to the duration of any Pre-Funding Period and
the Pre-Funding Limit for the Issuer.
Reports indicating the amount of payments of principal and interest
are provided to securityholders at least as frequently as distributions
are made to securityholders. Securityholders will also be provided with
periodic information statements setting forth material information
concerning the underlying assets, including, where applicable,
information as to the amount and number of delinquent and defaulted
loans or receivables.
In the case of an Issuer that offers and sells Securities in a
registered public offering, the Issuer, the Servicer or the Sponsor
will file such periodic reports as may be required to be filed under
the Securities Exchange Act of 1934. Although some Issuers that offer
Securities in a public offering will file quarterly reports on Form 10-
Q and Annual Reports on Form 10-K, many Issuers obtain, by application
to the Securities and Exchange Commission, relief from the requirement
to file quarterly reports on Form 10-Q and a modification of the
disclosure requirements for annual reports on Form 10-K. If such relief
is obtained, these Issuers normally would continue to have the
obligation to file current reports on Form 8-K to report material
developments concerning the Issuer and the Securities and copies of the
statements sent to securityholders. While the Securities and Exchange
Commission's interpretation of the periodic reporting requirements is
subject to change, periodic reports concerning an Issuer will be filed
to the extent required under the Securities Exchange Act of 1934.
At or about the time distributions are made to securityholders, a
report will be delivered to the Trustee as to the status of the Issuer
and its assets, including underlying obligations. Such report will
typically contain information regarding the Issuer's assets (including
those purchased by the Issuer from any Pre-Funding Account), payments
received or collected by the Servicer, the amount
[[Page 51487]]
of prepayments, delinquencies, Servicer advances, defaults and
foreclosures, the amount of any payments made pursuant to any credit
support, and the amount of compensation payable to the Servicer. Such
report also will be delivered to or made available to the Rating Agency
or Agencies that have rated the Securities.
In addition, promptly after each distribution date, securityholders
will receive a statement prepared by the Servicer, paying agent or
Trustee summarizing information regarding the Issuer and its assets.
Such statement will include information regarding the Issuer and its
assets, including underlying receivables. Such statement will typically
contain information regarding payments and prepayments, delinquencies,
the remaining amount of the guaranty or other credit support and a
breakdown of payments between principal and interest.
B. Secondary Market Transactions
It is the Applicant's normal policy to attempt to make a market for
Securities for which it is lead or co-managing Underwriter, and it is
the Applicant's intention to make a market for any Securities for which
the Applicant is a lead or co-managing Underwriter. At times the
Applicant will facilitate sales by investors who purchase Securities if
the Applicant has acted as agent or principal in the original private
placement of the Securities and if such investors request the
Applicant's assistance.
VII. Summary
In summary, the Applicant represents that the transactions for
which exemptive relief is requested satisfy the statutory criteria of
section 408(a) of the Act due to the following:
A. The Issuers contain ``fixed pools'' of assets. There is little
discretion on the part of the Sponsor to substitute receivables
contained in the Issuer once the Issuer has been formed;
B. In the case where a Pre-Funding Account is used, the
characteristics of the receivables to be transferred to the Issuer
during the Pre-Funding Period must be substantially similar to the
characteristics of those transferred to the Issuer on the Closing Date
thereby giving the Sponsor and/or originator little discretion over the
selection process, and compliance with this requirement will be assured
by the specificity of the characteristics and the monitoring mechanisms
contemplated under the amended exemptive relief proposed. In addition,
certain cash accounts will be established to support the Security
interest rate and such cash accounts will be invested in short-term,
conservative investments; the Pre-Funding Period will be of a
reasonably short duration; a pre-funding limit will be imposed; and any
Internal Revenue Service requirements with respect to pre-funding
intended to preserve the passive income character of the Issuer will be
met. The fiduciary of the plans making the decision to invest in
Securities is thus fully apprised of the nature of the receivables
which will be held in the Issuer and has sufficient information to make
a prudent investment decision;
C. Securities in which plans invest will have been rated in one of
the three highest generic rating categories (or four in the case of
Designated Transactions) by a Rating Agency. The Rating Agency, in
assigning a rating to such Securities, will take into account the fact
that Issuers may hold interest rate swaps or yield supplement
agreements with notional principal amounts or, in Designated
Transactions, Securities may be issued by Issuers holding residential
and home equity loans with LTV ratios in excess of 100%. Credit support
will be obtained to the extent necessary to attain the desired rating;
D. Securities will be issued by Issuers whose assets will be
protected from the claims of the Sponsor's creditors in the event of
bankruptcy or other insolvency of the Sponsor, and both equity and debt
securityholders will have a beneficial or security interest in the
receivables held by the Issuer. In addition, an independent Trustee
will represent the securityholders' interests in dealing with other
parties to the transaction;
E. All transactions for which the Underwriter seeks exemptive
relief will be governed by the Pooling and Servicing Agreement, the
principal provisions of which are described in the prospectus or
private placement memorandum and which is made available to plan
fiduciaries for their review prior to the plan's investment in
Securities;
F. Exemptive relief from sections 406(b) and 407 for sales to plans
is substantially limited; and
G. The Underwriter has made, and anticipates that it will continue
to make, a secondary market in Securities.
Notice to Interested Persons
The applicant represents that because those potentially interested
participants and beneficiaries cannot all be identified, the only
practical means of notifying such participants and beneficiaries of
this proposed exemption is by the publication of this notice in the
Federal Register. Comments and requests for a hearing must be received
by the Department not later than 45 days from the date of publication
of this notice of proposed exemption in the Federal Register.
General Information
The attention of interested persons is directed to the following:
1. The fact that a transaction is the subject of an exemption under
section 408(a) of the Act and section 4975(c)(2) of the Code does not
relieve a fiduciary or other party in interest or disqualified person
from certain other provisions of the Act and the Code, including any
prohibited transaction provisions to which the exemption does not apply
and the general fiduciary responsibility provisions of section 404 of
the Act, which require, among other things, a fiduciary to discharge
his or her duties respecting the plan solely in the interest of the
participants and beneficiaries of the plan and in a prudent fashion in
accordance with section 404(a)(1)(B) of the Act; nor does it affect the
requirements of section 401(a) of the Code that the plan operate for
the exclusive benefit of the employees of the employer maintaining the
plan and their beneficiaries;
2. Before an exemption can be granted under section 408(a) of the
Act and section 4975(c)(2) of the Code, the Department must find that
the exemption is administratively feasible, in the interest of the
plans and of their participants and beneficiaries and protective of the
rights of participants and beneficiaries of the plans;
3. The proposed amendment, if granted, will be supplemental to, and
not in derogation of, any other provisions of the Act and/or the Code,
including statutory or administrative exemptions and transitional
rules. Furthermore, the fact that a transaction is subject to an
administrative or statutory exemption is not dispositive of whether the
transaction is in fact a prohibited transaction; and
4. The proposed amendment, if granted, will be subject to the
express condition that the material facts and representations contained
in each application are true and complete and accurately describe all
material terms of the transaction which is the subject of the
exemption.
Written Comments and Hearing Requests
All interested persons are invited to submit written comments or
requests for a hearing on the proposed amendment to the address above,
within the time period set forth above. All comments will be made a
part of the record. Comments and requests for a hearing
[[Page 51488]]
should state the reasons for the writer's interest in the proposed
amendment. Comments received will be available for public inspection
with the referenced applications at the address set forth above.
Proposed Exemption
Under section 408(a) of ERISA and section 4975(c)(2) of the Code
and in accordance with the procedures set forth in 29 CFR Part 2570,
subpart B (55 FR 32836, August 10, 1990), the Department proposes to
amend the following individual Prohibited Transaction Exemptions
(PTEs): PTE 89-88, 54 FR 42582 (October 17, 1989); PTE 89-89, 54 FR
42569 (October 17, 1989); PTE 89-90, 54 FR 42597 (October 17, 1989);
PTE 90-22, 55 FR 20542 (May 17, 1990); PTE 90-23, 55 FR 20545 (May 17,
1990); PTE 90-24, 55 FR 20548 (May 17, 1990); PTE 90-28, 55 FR 21456
(May 24, 1990); PTE 90-29, 55 FR 21459 (May 24, 1990); PTE 90-30, 55 FR
21461 (May 24, 1990); PTE 90-31, 55 FR 23144 (June 6, 1990); PTE 90-32,
55 FR 23147 (June 6, 1990); PTE 90-33, 55 FR 23151 (June 6, 1990); PTE
90-36, 55 FR 25903 (June 25, 1990); PTE 90-39, 55 FR 27713 (July 5,
1990); PTE 90-59, 55 FR 36724 (September 6, 1990); PTE 90-83, 55 FR
50250 (December 5, 1990); PTE 90-84, 55 FR 50252 (December 5, 1990);
PTE 90-88, 55 FR 52899 (December 24, 1990); PTE 91-14, 55 FR 48178
(February 22, 1991); PTE 91-22, 56 FR 03277 (April 18, 1991); PTE 91-
23, 56 FR 15936 (April 18, 1991); PTE 91-30, 56 FR 22452 (May 15,
1991); PTE 91-62, 56 FR 51406 (October 11, 1991); PTE 93-31, 58 FR
28620 (May 5, 1993); PTE 93-32, 58 FR 28623 (May 14, 1993); PTE 94-29,
59 FR 14675 (March 29, 1994); PTE 94-64, 59 FR 42312 (August 17, 1994);
PTE 94-70, 59 FR 50014 (September 30, 1994); PTE 94-73, 59 FR 51213
(October 7, 1994); PTE 94-84, 59 FR 65400 (December 19, 1994); PTE 95-
26, 60 FR 17586 (April 6, 1995); PTE 95-59, 60 FR 35938 (July 12,
1995); PTE 95-89, 60 FR 49011 (September 21, 1995); PTE 96-22, 61 FR
14828 (April 3, 1996); PTE 96-84, 61 FR 58234 (November 13, 1996); PTE
96-92, 61 FR 66334 (December 17, 1996); PTE 96-94, 61 FR 68787
(December 30, 1996); PTE 97-05, 62 FR 1926 (January 14, 1997); PTE 97-
28, 62 FR 28515 (May 23, 1997); PTE 97-34, 62 FR 39021 (July 21, 1997);
PTE 98-08, 63 FR 8498 (February 19, 1998); PTE 99-11, 64 FR 11046
(March 8, 1999); PTE 2000-19, 65 FR 25950 (May 4, 2000); PTE 2000-33,
65 FR 37171 (June 13, 2000); and PTE 2000-41, First Tennessee National
Corporation (August, 2000).
In addition, the Department notes that it is also proposing
individual exemptive relief for: Deutsche Bank AG, New York Branch and
Deutsche Morgan Grenfell/C.J. Lawrence Inc., FAN 97-03E (December 9,
1996); Credit Lyonnais Securities (USA) Inc., FAN 97-21E (September 10,
1997); ABN AMRO Inc., FAN 98-08E (April 27, 1998); and Ironwood Capital
Partners Ltd., FAN 99-31E (December 20, 1999). They have received the
approval of the Department to engage in transactions substantially
similar to the transactions described in the Underwriter Exemptions
pursuant to PTE 96-62. Finally, the Department notes that it is
proposing relief for Countrywide Securities Corporation (Application
No. D-10863).
I. Transactions
A. Effective for transactions occurring on or after the date of
publication of this notice in the Federal Register, the restrictions of
sections 406(a) and 407(a) of the Act, and the taxes imposed by
sections 4975(a) and (b) of the Code, by reason of section
4975(c)(1)(A) through (D) of the Code shall not apply to the following
transactions involving Issuers and Securities evidencing interests
therein:
(1) The direct or indirect sale, exchange or transfer of Securities
in the initial issuance of Securities between the Sponsor or
Underwriter and an employee benefit plan when the Sponsor, Servicer,
Trustee or Insurer of an Issuer, the Underwriter of the Securities
representing an interest in the Issuer, or an Obligor is a party in
interest with respect to such plan;
(2) The direct or indirect acquisition or disposition of Securities
by a plan in the secondary market for such Securities; and
(3) The continued holding of Securities acquired by a plan pursuant
to subsection I.A.(1) or (2).
Notwithstanding the foregoing, section I.A. does not provide an
exemption from the restrictions of sections 406(a)(1)(E), 406(a)(2) and
407 of the Act for the acquisition or holding of a Security on behalf
of an Excluded Plan by any person who has discretionary authority or
renders investment advice with respect to the assets of that Excluded
Plan.\37\
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\37\ Section I.A. provides no relief from sections 406(a)(1)(E),
406(a)(2) and 407 of the Act for any person rendering investment
advice to an Excluded Plan within the meaning of section
3(21)(A)(ii) of the Act, and regulation 29 CFR 2510.3-21(c).
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B. Effective for transactions occurring on or after the date of
publication of this notice in the Federal Register, the restrictions of
sections 406(b)(1) and 406(b)(2) of the Act and the taxes imposed by
sections 4975(a) and (b) of the Code, by reason of section
4975(c)(1)(E) of the Code, shall not apply to:
(1) The direct or indirect sale, exchange or transfer of Securities
in the initial issuance of Securities between the Sponsor or
Underwriter and a plan when the person who has discretionary authority
or renders investment advice with respect to the investment of plan
assets in the Securities is (a) an Obligor with respect to 5 percent or
less of the fair market value of obligations or receivables contained
in the Issuer, or (b) an Affiliate of a person described in (a); if:
(i) The plan is not an Excluded Plan;
(ii) Solely in the case of an acquisition of Securities in
connection with the initial issuance of the Securities, at least 50
percent of each class of Securities in which plans have invested is
acquired by persons independent of the members of the Restricted Group
and at least 50 percent of the aggregate interest in the Issuer is
acquired by persons independent of the Restricted Group;
(iii) A plan's investment in each class of Securities does not
exceed 25 percent of all of the Securities of that class outstanding at
the time of the acquisition; and
(iv) Immediately after the acquisition of the Securities, no more
than 25 percent of the assets of a plan with respect to which the
person has discretionary authority or renders investment advice are
invested in Securities representing an interest in an Issuer containing
assets sold or serviced by the same entity.\38\ For purposes of this
paragraph (iv) only, an entity will not be considered to service assets
contained in a Issuer if it is merely a Subservicer of that Issuer;
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\38\ For purposes of this Underwriter Exemption, each plan
participating in a commingled fund (such as a bank collective trust
fund or insurance company pooled separate account) shall be
considered to own the same proportionate undivided interest in each
asset of the commingled fund as its proportionate interest in the
total assets of the commingled fund as calculated on the most recent
preceding valuation date of the fund.
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(2) The direct or indirect acquisition or disposition of Securities
by a plan in the secondary market for such Securities, provided that
the conditions set forth in paragraphs (i), (iii) and (iv) of
subsection I.B.(1) are met; and
(3) The continued holding of Securities acquired by a plan pursuant
to subsection I.B.(1) or (2).
C. Effective for transaction occurring on or after the date of
publication of this notice in the Federal Register, the restrictions of
sections 406(a), 406(b) and 407(a) of the Act, and the taxes imposed by
section 4975(a) and (b) of
[[Page 51489]]
the Code by reason of section 4975(c) of the Code, shall not apply to
transactions in connection with the servicing, management and operation
of an Issuer, including the use of any Eligible Swap Transaction; or,
effective January 1, 1999, the defeasance of a mortgage obligation held
as an asset of the Issuer through the substitution of a new mortgage
obligation in a commercial mortgage-backed Designated Transaction,
provided:
(1) Such transactions are carried out in accordance with the terms
of a binding Pooling and Servicing Agreement;
(2) The Pooling and Servicing Agreement is provided to, or
described in all material respects in the prospectus or private
placement memorandum provided to, investing plans before they purchase
Securities issued by the Issuer; \39\ and
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\39\ In the case of a private placement memorandum, such
memorandum must contain substantially the same information that
would be disclosed in a prospectus if the offering of the securities
were made in a registered public offering under the Securities Act
of 1933. In the Department's view, the private placement memorandum
must contain sufficient information to permit plan fiduciaries to
make informed investment decisions. For purposes of this exemption,
references to ``prospectus'' include any related prospectus
supplement thereto, pursuant to which Securities are offered to
investors.
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(3) The defeasance of a mortgage obligation and the substitution of
a new mortgage obligation in a commercial mortgage-backed Designated
Transaction meet the terms and conditions for such defeasance and
substitution as are described in the prospectus or private placement
memorandum for such Securities, which terms and conditions have been
approved by a Rating Agency and does not result in the Securities
receiving a lower credit rating from the Rating Agency than the current
rating of the Securities.
Notwithstanding the foregoing, section I.C. does not provide an
exemption from the restrictions of section 406(b) of the Act or from
the taxes imposed by reason of section 4975(c) of the Code for the
receipt of a fee by a Servicer of the Issuer from a person other than
the Trustee or Sponsor, unless such fee constitutes a Qualified
Administrative Fee.
D. Effective for transactions occurring on or after the date of
publication of this notice in the Federal Register, the restrictions of
sections 406(a) and 407(a) of the Act, and the taxes imposed by section
4975(a) and (b) of the Code by reason of section 4975(c)(1)(A) through
(D) of the Code, shall not apply to any transactions to which those
restrictions or taxes would otherwise apply merely because a person is
deemed to be a party in interest or disqualified person (including a
fiduciary) with respect to a plan by virtue of providing services to
the plan (or by virtue of having a relationship to such service
provider described in section 3(14)(F), (G), (H) or (I) of the Act or
section 4975(e)(2)(F), (G), (H) or (I) of the Code), solely because of
the plan's ownership of Securities.
II. General Conditions
A. The relief provided under section I. is available only if the
following conditions are met:
(1) The acquisition of Securities by a plan is on terms (including
the Security price) that are at least as favorable to the plan as they
would be in an arm's-length transaction with an unrelated party;
(2) The rights and interests evidenced by the Securities are not
subordinated to the rights and interests evidenced by other Securities
of the same Issuer, unless the Securities are issued in a Designated
Transaction;
(3) The Securities acquired by the plan have received a rating from
a Rating Agency at the time of such acquisition that is in one of the
three (or in the case of Designated Transactions, four) highest generic
rating categories;
(4) The Trustee is not an Affiliate of any member of the Restricted
Group. For purposes of this requirement:
(a) The Trustee shall not be considered to be an Affiliate of a
Servicer solely because the Trustee has succeeded to the rights and
responsibilities of the Servicer pursuant to the terms of a Pooling and
Servicing Agreement providing for such succession upon the occurrence
of one or more events of default by the Servicer; and
(b) Effective for transactions occurring on or after January 1,
1998, subsection II.A.(4) will be deemed satisfied notwithstanding a
Servicer becoming an Affiliate of the Trustee as the result of a merger
or acquisition involving the Trustee, such Servicer and/or their
Affiliates which occurs after the initial issuance of the Securities,
provided that:
(i) such Servicer ceases to be an Affiliate of the Trustee no later
than six months after the later of August 23, 2000, or the date such
Servicer became an Affiliate of the Trustee; and
(ii) such Servicer did not breach any of its obligations under the
Pooling and Servicing Agreement, unless such breach was immaterial and
timely cured in accordance with the terms of such agreement, during the
period from the closing date of such merger or acquisition transaction
through the date the Servicer ceased to be an Affiliate of the Trustee;
(5) The sum of all payments made to and retained by the
Underwriters in connection with the distribution or placement of
Securities represents not more than Reasonable Compensation for
underwriting or placing the Securities; the sum of all payments made to
and retained by the Sponsor pursuant to the assignment of obligations
(or interests therein) to the Issuer represents not more than the fair
market value of such obligations (or interests); and the sum of all
payments made to and retained by the Servicer represents not more than
Reasonable Compensation for the Servicer's services under the Pooling
and Servicing Agreement and reimbursement of the Servicer's reasonable
expenses in connection therewith;
(6) The plan investing in such Securities is an ``accredited
investor'' as defined in Rule 501(a)(1) of Regulation D of the
Securities and Exchange Commission under the Securities Act of 1933;
and
(7) In the event that the obligations used to fund a Issuer have
not all been transferred to the Issuer on the Closing Date, additional
obligations of the types specified in subsection III.B.(1) may be
transferred to the Issuer during the Pre-Funding Period in exchange for
amounts credited to the Pre-Funding Account, provided that:
(a) The Pre-Funding Limit is not exceeded;
(b) All such additional obligations meet the same terms and
conditions for determining the eligibility of the original obligations
used to create the Issuer (as described in the prospectus or private
placement memorandum and/or Pooling and Servicing Agreement for such
Securities), which terms and conditions have been approved by a Rating
Agency. Notwithstanding the foregoing, the terms and conditions for
determining the eligibility of an obligation may be changed if such
changes receive prior approval either by a majority vote of the
outstanding securityholders or by a Rating Agency;
(c) The transfer of such additional obligations to the Issuer
during the Pre-Funding Period does not result in the Securities
receiving a lower credit rating from a Rating Agency upon termination
of the Pre-Funding Period than the rating that was obtained at the time
of the initial issuance of the Securities by the Issuer;
(d) The weighted average annual percentage interest rate (the
average interest rate) for all of the obligations
[[Page 51490]]
held by the Issuer at the end of the Pre-Funding Period will not be
more than 100 basis points lower than the average interest rate for the
obligations which were transferred to the Issuer on the Closing Date;
(e) In order to ensure that the characteristics of the receivables
actually acquired during the Pre-Funding Period are substantially
similar to those which were acquired as of the Closing Date, the
characteristics of the additional obligations will either be monitored
by a credit support provider or other insurance provider which is
independent of the Sponsor or an independent accountant retained by the
Sponsor will provide the Sponsor with a letter (with copies provided to
the Rating Agency, the Underwriter and the Trustee) stating whether or
not the characteristics of the additional obligations conform to the
characteristics of such obligations described in the prospectus,
private placement memorandum and/or Pooling and Servicing Agreement. In
preparing such letter, the independent accountant will use the same
type of procedures as were applicable to the obligations which were
transferred as of the Closing Date;
(f) The Pre-Funding Period shall be described in the prospectus or
private placement memorandum provided to investing plans; and
(g) The Trustee of the Trust (or any agent with which the Trustee
contracts to provide Trust services) will be a substantial financial
institution or trust company experienced in trust activities and
familiar with its duties, responsibilities and liabilities as a
fiduciary under the Act. The Trustee, as the legal owner of the
obligations in the Trust or the holder of a security interest in the
obligations held by the Issuer, will enforce all the rights created in
favor of securityholders of the Issuer, including employee benefit
plans subject to the Act;
(8) In order to insure that the assets of the Issuer may not be
reached by creditors of the Sponsor in the event of bankruptcy or other
insolvency of the Sponsor:
(a) The legal documents establishing the Issuer will contain:
(i) Restrictions on the Issuer's ability to borrow money or issue
debt other than in connection with the securitization;
(ii) Restrictions on the Issuer merging with another entity,
reorganizing, liquidating or selling assets (other than in connection
with the securitization);
(iii) Restrictions limiting the authorized activities of the Issuer
to activities relating to the securitization;
(iv) If the Issuer is not a Trust, provisions for the election of
at least one independent director/partner/member whose affirmative
consent is required before a voluntary bankruptcy petition can be filed
by the Issuer; and
(v) If the Issuer is not a Trust, requirements that each
independent director/partner/member must be an individual that does not
have a significant interest in, or other relationships with, the
Sponsor or any of its Affiliates; and
(b) The Pooling and Servicing Agreement and/or other agreements
establishing the contractual relationships between the parties to the
securitization transaction will contain covenants prohibiting all
parties thereto from filing an involuntary bankruptcy petition against
the Issuer or initiating any other form of insolvency proceeding until
after the Securities have been paid; and
(c) Prior to the issuance by the Issuer of any Securities, a legal
opinion is received which states that either:
(i) A ``true sale'' of the assets being transferred to the Issuer
by the Sponsor has occurred and that such transfer is not being made
pursuant to a financing of the assets by the Sponsor; or
(ii) In the event of insolvency or receivership of the Sponsor, the
assets transferred to the Issuer will not be part of the estate of the
Sponsor;
(9) If a particular class of Securities held by any plan involves a
Ratings Dependent or Non-Ratings Dependent Swap entered into by the
Issuer, then each particular swap transaction relating to such
Securities:
(a) Shall be an Eligible Swap;
(b) Shall be with an Eligible Swap Counterparty;
(c) In the case of a Ratings Dependent Swap, shall provide that if
the credit rating of the counterparty is withdrawn or reduced by any
Rating Agency below a level specified by the Rating Agency, the
Servicer (as agent for the Trustee) shall, within the period specified
under the Pooling and Servicing Agreement:
(i) Obtain a replacement swap agreement with an Eligible Swap
Counterparty which is acceptable to the Rating Agency and the terms of
which are substantially the same as the current swap agreement (at
which time the earlier swap agreement shall terminate); or
(ii) Cause the swap counterparty to establish any collateralization
or other arrangement satisfactory to the Rating Agency such that the
then current rating by the Rating Agency of the particular class of
Securities will not be withdrawn or reduced.
In the event that the Servicer fails to meet its obligations under
this subsection II.A.(9)(c), plan securityholders will be notified in
the immediately following Trustee's periodic report which is provided
to securityholders, and sixty days after the receipt of such report,
the exemptive relief provided under section I.C. will prospectively
cease to be applicable to any class of Securities held by a plan which
involves such Ratings Dependent Swap; provided that in no event will
such plan securityholders be notified any later than the end of the
second month that begins after the date on which such failure occurs.
(d) In the case of a Non-Ratings Dependent Swap, shall provide
that, if the credit rating of the counterparty is withdrawn or reduced
below the lowest level specified in section III.GG., the Servicer (as
agent for the Trustee) shall within a specified period after such
rating withdrawal or reduction:
(i) Obtain a replacement swap agreement with an Eligible Swap
Counterparty, the terms of which are substantially the same as the
current swap agreement (at which time the earlier swap agreement shall
terminate); or
(ii) Cause the swap counterparty to post collateral with the
Trustee in an amount equal to all payments owed by the counterparty if
the swap transaction were terminated; or
(iii) Terminate the swap agreement in accordance with its terms;
and
(e) Shall not require the Issuer to make any termination payments
to the counterparty (other than a currently scheduled payment under the
swap agreement) except from Excess Spread or other amounts that would
otherwise be payable to the Servicer or the Sponsor;
(10) Any class of Securities, to which one or more swap agreements
entered into by the Issuer applies, may be acquired or held in reliance
upon this Underwriter Exemption only by Qualified Plan Investors; and
(11) Prior to the issuance of any debt securities, a legal opinion
is received which states that the debt holders have a perfected
security interest in the Issuer's assets.
B. Neither any Underwriter, Sponsor, Trustee, Servicer, Insurer or
any Obligor, unless it or any of its Affiliates has discretionary
authority or renders investment advice with respect to the plan assets
used by a plan to acquire Securities, shall be denied the relief
provided under section I., if the provision of subsection II.A.(6) is
not satisfied with respect to acquisition or holding by a plan of such
Securities,
[[Page 51491]]
provided that (1) such condition is disclosed in the prospectus or
private placement memorandum; and (2) in the case of a private
placement of Securities, the Trustee obtains a representation from each
initial purchaser which is a plan that it is in compliance with such
condition, and obtains a covenant from each initial purchaser to the
effect that, so long as such initial purchaser (or any transferee of
such initial purchaser's Securities) is required to obtain from its
transferee a representation regarding compliance with the Securities
Act of 1933, any such transferees will be required to make a written
representation regarding compliance with the condition set forth in
subsection II.A.(6).
III. Definitions
For purposes of this exemption:
A. ``Security'' means:
(1) A pass-through certificate or trust certificate that represents
a beneficial ownership interest in the assets of an Issuer which is a
Trust and which entitles the holder to payments of principal, interest
and/or other payments made with respect to the assets of such Trust; or
(2) A security which is denominated as a debt instrument that is
issued by, and is an obligation of, an Issuer; with respect to which
the Underwriter is either (i) the sole underwriter or the manager or
co-manager of the underwriting syndicate, or (ii) a selling or
placement agent.
B. ``Issuer'' means an investment pool, the corpus or assets of
which are held in trust (including a grantor or owner Trust) or whose
assets are held by a partnership, special purpose corporation or
limited liability company (which Issuer may be a Real Estate Mortgage
Investment Conduit (REMIC) or a Financial Asset Securitization
Investment Trust (FASIT) within the meaning of section 860D(a) or
section 860L, respectively, of the Code); and the corpus or assets of
which consist solely of:
(1)(a) Secured consumer receivables that bear interest or are
purchased at a discount (including, but not limited to, home equity
loans and obligations secured by shares issued by a cooperative housing
association); and/or
(b) Secured credit instruments that bear interest or are purchased
at a discount in transactions by or between business entities
(including, but not limited to, Qualified Equipment Notes Secured by
Leases); and/or
(c) Obligations that bear interest or are purchased at a discount
and which are secured by single-family residential, multi-family
residential and/or commercial real property (including obligations
secured by leasehold interests on residential or commercial real
property); and/or
(d) Obligations that bear interest or are purchased at a discount
and which are secured by motor vehicles or equipment, or Qualified
Motor Vehicle Leases; and/or
(e) Guaranteed governmental mortgage pool certificates, as defined
in 29 CFR 2510.3-101(i)(2); \40\ and/or
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\40\ In Advisory Opinion 99-05A (Feb. 22, 1999), the Department
expressed its view that mortgage pool certificates guaranteed and
issued by the Federal Agricultural Mortgage Corporation (``Farmer
Mac'') meet the definition of a guaranteed governmental mortgage
pool certificate as defined in 29 CFR 2510.3-101(i)(2).
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(f) Fractional undivided interests in any of the obligations
described in clauses (a)-(e) of this subsection B.(1).\41\
---------------------------------------------------------------------------
\41\ The Department wishes to take the opportunity to clarify
its view that the definition of Issuer contained in subsection
III.B. includes a two-tier structure under which Securities issued
by the first Issuer, which contains a pool of receivables described
above, are transferred to a second Issuer which issues Securities
that are sold to plans. However, the Department is of the further
view that, since the Underwriter Exemption generally provides relief
only for the direct or indirect acquisition or disposition of
Securities that are not subordinated, no relief would be available
if the Securities held by the second Issuer were subordinated to the
rights and interests evidenced by other Securities issued by the
first Issuer, unless such Securities were issued in a Designated
Transaction.
---------------------------------------------------------------------------
Notwithstanding the foregoing, residential and home equity loan
receivables issued in Designated Transactions may be less than fully
secured, provided that: (i) the rights and interests evidenced by the
Securities issued in such Designated Transactions (as defined in
section III.DD.) are not subordinated to the rights and interests
evidenced by Securities of the same Issuer; (ii) such Securities
acquired by the plan have received a rating from a Rating Agency at the
time of such acquisition that is in one of the two highest generic
rating categories; and (iii) any obligation included in the corpus or
assets of the Issuer must be secured by collateral whose fair market
value on the Closing Date of the Designated Transaction is at least
equal to 80% of the sum of: (I) the outstanding principal balance due
under the obligation which is held by the Issuer and (II) the
outstanding principal balance(s) of any other obligation(s) of higher
priority (whether or not held by the Issuer) which are secured by the
same collateral.
(2) Property which had secured any of the obligations described in
subsection III.B.(1);
(3)(a) Undistributed cash or temporary investments made therewith
maturing no later than the next date on which distributions are made to
securityholders; and/or
(b) Cash or investments made therewith which are credited to an
account to provide payments to securityholders pursuant to any Eligible
Swap Agreement meeting the conditions of subsection II.A.(9) or
pursuant to any Eligible Yield Supplement Agreement; and/or
(c) Cash transferred to the Issuer on the Closing Date and
permitted investments made therewith which:
(i) Are credited to a Pre-Funding Account established to purchase
additional obligations with respect to which the conditions set forth
in paragraphs (a)-(g) of subsection II.A.(7) are met; and/or
(ii) Are credited to a Capitalized Interest Account; and
(iii) Are held by the Issuer for a period ending no later than the
first distribution date to securityholders occurring after the end of
the Pre-Funding Period.
For purposes of this paragraph (c) of subsection III.B.(3), the
term ``permitted investments'' means investments which: (i) Are either:
(x) direct obligations of, or obligations fully guaranteed as to timely
payment of principal and interest by, the United States or any agency
or instrumentality thereof, provided that such obligations are backed
by the full faith and credit of the United States or (y) have been
rated (or the Obligor has been rated) in one of the three highest
generic rating categories by a Rating Agency; (ii) are described in the
Pooling and Servicing Agreement; and (iii) are permitted by the Rating
Agency.
(4) Rights of the Trustee under the Pooling and Servicing
Agreement, and rights under any insurance policies, third-party
guarantees, contracts of suretyship, Eligible Yield Supplement
Agreements, Eligible Swap Agreements meeting the conditions of
subsection II.A.(9) or other credit support arrangements with respect
to any obligations described in subsection III.B.(1).
Notwithstanding the foregoing, the term ``Issuer'' does not include
any investment pool unless: (i) The assets of the type described in
paragraphs (a)-(f) of subsection III.B.(1) which are contained in the
investment pool have been included in other investment pools, (ii)
Securities evidencing interests in such other investment pools have
been rated in one of the three (or in the case of Designated
Transactions, four) highest generic rating categories by a Rating
Agency for at least one year prior to the plan's acquisition of
Securities pursuant to this Underwriter
[[Page 51492]]
Exemption, and (iii) Securities evidencing interests in such other
investment pools have been purchased by investors other than plans for
at least one year prior to the plan's acquisition of Securities
pursuant to this Underwriter Exemption.
C. ``Underwriter'' means:
(1) An entity defined as an Underwriter in subsection III.C.(1) of
each of the Underwriter Exemptions that are being amended by this
proposed exemption. In addition, the term Underwriter includes Deutsche
Bank AG, New York Branch and Deutsche Morgan Grenfell/C.J. Lawrence
Inc, Credit Lyonnais Securities (USA) Inc., ABN AMRO Inc. and Ironwood
Capital Partners Ltd. (which received the approval of the Department to
engage in transactions substantially similar to the transactions
described in the Underwriter Exemptions pursuant to PTE 96-62);
(2) Any person directly or indirectly, through one or more
intermediaries, controlling, controlled by or under common control with
such entity; or
(3) Any member of an underwriting syndicate or selling group of
which a person described in subsections III.C.(1) or (2) is a manager
or co-manager with respect to the Securities.
D. ``Sponsor'' means the entity that organizes an Issuer by
depositing obligations therein in exchange for Securities.
E. ``Master Servicer'' means the entity that is a party to the
Pooling and Servicing Agreement relating to assets of the Issuer and is
fully responsible for servicing, directly or through Subservicers, the
assets of the Issuer.
F. ``Subservicer'' means an entity which, under the supervision of
and on behalf of the Master Servicer, services loans contained in the
Issuer, but is not a party to the Pooling and Servicing Agreement.
G. ``Servicer'' means any entity which services loans contained in
the Issuer, including the Master Servicer and any Subservicer.
H. ``Trust'' means an Issuer which is a trust (including an owner
trust, grantor trust or a REMIC or FASIT which is organized as a
Trust).
I. ``Trustee'' means the Trustee of any Trust which issues
Securities and also includes an Indenture Trustee. ``Indenture
Trustee'' means the Trustee appointed under the indenture pursuant to
which the subject Securities are issued, the rights of holders of the
Securities are set forth and a security interest in the Trust assets in
favor of the holders of the Securities is created. The Trustee or the
Indenture Trustee is also a party to or beneficiary of all the
documents and instruments transferred to the Issuer, and as such, has
both the authority to, and the responsibility for, enforcing all the
rights created thereby in favor of holders of the Securities, including
those rights arising in the event of default by the servicer.
J. ``Insurer'' means the insurer or guarantor of, or provider of
other credit support for, an Issuer. Notwithstanding the foregoing, a
person is not an insurer solely because it holds Securities
representing an interest in an Issuer which are of a class subordinated
to Securities representing an interest in the same Issuer.
K. ``Obligor'' means any person, other than the Insurer, that is
obligated to make payments with respect to any obligation or receivable
included in the Issuer. Where an Issuer contains Qualified Motor
Vehicle Leases or Qualified Equipment Notes Secured by Leases,
``Obligor'' shall also include any owner of property subject to any
lease included in the Issuer, or subject to any lease securing an
obligation included in the Issuer.
L. ``Excluded Plan'' means any plan with respect to which any
member of the Restricted Group is a ``plan sponsor'' within the meaning
of section 3(16)(B) of the Act.
M. ``Restricted Group'' with respect to a class of Securities
means:
(1) Each Underwriter;
(2) Each Insurer;
(3) The Sponsor;
(4) The Trustee;
(5) Each Servicer;
(6) Any Obligor with respect to obligations or receivables included
in the Issuer constituting more than 5 percent of the aggregate
unamortized principal balance of the assets in the Issuer, determined
on the date of the initial issuance of Securities by the Issuer;
(7) Each counterparty in an Eligible Swap Agreement; or
(8) Any Affiliate of a person described in subsections III.M.(1)-
(7).
N. ``Affiliate'' of another person includes:
(1) Any person directly or indirectly, through one or more
intermediaries, controlling, controlled by, or under common control
with such other person;
(2) Any officer, director, partner, employee, relative (as defined
in section 3(15) of the Act), a brother, a sister, or a spouse of a
brother or sister of such other person; and
(3) Any corporation or partnership of which such other person is an
officer, director or partner.
O. ``Control'' means the power to exercise a controlling influence
over the management or policies of a person other than an individual.
P. A person will be ``independent'' of another person only if:
(1) Such person is not an Affiliate of that other person; and
(2) The other person, or an Affiliate thereof, is not a fiduciary
who has investment management authority or renders investment advice
with respect to any assets of such person.
Q. ``Sale'' includes the entrance into a Forward Delivery
Commitment, provided:
(1) The terms of the Forward Delivery Commitment (including any fee
paid to the investing plan) are no less favorable to the plan than they
would be in an arm's-length transaction with an unrelated party;
(2) The prospectus or private placement memorandum is provided to
an investing plan prior to the time the plan enters into the Forward
Delivery Commitment; and
(3) At the time of the delivery, all conditions of this Underwriter
Exemption applicable to sales are met.
R. ``Forward Delivery Commitment'' means a contract for the
purchase or sale of one or more Securities to be delivered at an agreed
future settlement date. The term includes both mandatory contracts
(which contemplate obligatory delivery and acceptance of the
Securities) and optional contracts (which give one party the right but
not the obligation to deliver Securities to, or demand delivery of
Securities from, the other party).
S. ``Reasonable Compensation'' has the same meaning as that term is
defined in 29 CFR 2550.408c-2.
T. ``Qualified Administrative Fee'' means a fee which meets the
following criteria:
(1) The fee is triggered by an act or failure to act by the Obligor
other than the normal timely payment of amounts owing in respect of the
obligations;
(2) The Servicer may not charge the fee absent the act or failure
to act referred to in subsection III.T.(1);
(3) The ability to charge the fee, the circumstances in which the
fee may be charged, and an explanation of how the fee is calculated are
set forth in the Pooling and Servicing Agreement; and
(4) The amount paid to investors in the Issuer will not be reduced
by the amount of any such fee waived by the Servicer.
U. ``Qualified Equipment Note Secured By A Lease'' means an
equipment note:
(1) Which is secured by equipment which is leased;
(2) Which is secured by the obligation of the lessee to pay rent
under the equipment lease; and
[[Page 51493]]
(3) With respect to which the Issuer's security interest in the
equipment is at least as protective of the rights of the Issuer as the
Issuer would have if the equipment note were secured only by the
equipment and not the lease.
V. ``Qualified Motor Vehicle Lease'' means a lease of a motor
vehicle where:
(1) The Issuer owns or holds a security interest in the lease;
(2) The Issuer owns or holds a security interest in the leased
motor vehicle; and
(3) The Issuer's security interest in the leased motor vehicle is
at least as protective of the Issuer's rights as the Issuer would
receive under a motor vehicle installment loan contract.
W. ``Pooling and Servicing Agreement'' means the agreement or
agreements among a Sponsor, a Servicer and the Trustee establishing a
Trust. ``Pooling and Servicing Agreement'' also includes the indenture
entered into by the Issuer and the Indenture Trustee.
X. ``Rating Agency'' means Standard & Poor's Ratings Services, a
division of The McGraw-Hill Companies Inc., Moody's Investors Service,
Inc., Duff & Phelps Credit Rating Co., Fitch ICBA, Inc. or any
successors thereto.
Y. ``Capitalized Interest Account'' means an Issuer account:
(i) which is established to compensate securityholders for
shortfalls, if any, between investment earnings on the Pre-Funding
Account and the interest rate payable under the Securities; and (ii)
which meets the requirements of paragraph (c) of subsection III.B.(3).
Z. ``Closing Date'' means the date the Issuer is formed, the
Securities are first issued and the Issuer's assets (other than those
additional obligations which are to be funded from the Pre-Funding
Account pursuant to subsection II.A.(7)) are transferred to the Issuer.
AA. ``Pre-Funding Account'' means an Issuer account: (i) which is
established to purchase additional obligations, which obligations meet
the conditions set forth in paragraph (a)-(g) of subsection II.A.(7);
and (ii) which meets the requirements of paragraph (c) of subsection
III.B.(3).
BB. ``Pre-Funding Limit'' means a percentage or ratio of the amount
allocated to the Pre-Funding Account, as compared to the total
principal amount of the Securities being offered, which is less than or
equal to: (i) 40 percent, effective for transactions occurring on or
after January 1, 1992, but prior to May 23, 1997; and (ii) 25 percent,
for transactions occurring on or after May 23, 1997.
CC. ``Pre-Funding Period'' means the period commencing on the
Closing Date and ending no later than the earliest to occur of: (i) the
date the amount on deposit in the Pre-Funding Account is less than the
minimum dollar amount specified in the Pooling and Servicing Agreement;
(ii) the date on which an event of default occurs under the Pooling and
Servicing Agreement or (iii) the date which is the later of three
months or ninety days after the Closing Date.
DD. ``Designated Transaction'' means a securitization transaction
in which the assets of the Issuer consist of secured consumer
receivables, secured credit instruments or secured obligations that
bear interest or are purchased at a discount and are: (i) Motor
vehicle, home equity and/or manufactured housing consumer receivables;
and/or (ii) motor vehicle credit instruments in transactions by or
between business entities; and/or (iii) single-family residential,
multi-family residential, home equity, manufactured housing and/or
commercial mortgage obligations that are secured by single-family
residential, multi-family residential, commercial real property or
leasehold interests therein. For purposes of this section III.DD., the
collateral securing motor vehicle consumer receivables or motor vehicle
credit instruments may include motor vehicles and/or Qualified Motor
Vehicle Leases.
EE. ``Ratings Dependent Swap'' means an interest rate swap, or (if
purchased by or on behalf of the Issuer) an interest rate cap contract,
that is part of the structure of a class of Securities where the rating
assigned by the Rating Agency to any class of Securities held by any
plan is dependent on the terms and conditions of the swap and the
rating of the counterparty, and if such Security rating is not
dependent on the existence of the swap and rating of the counterparty,
such swap or cap shall be referred to as a ``Non-Ratings Dependent
Swap''. With respect to a Non-Ratings Dependent Swap, each Rating
Agency rating the Securities must confirm, as of the date of issuance
of the Securities by the Issuer, that entering into an Eligible Swap
with such counterparty will not affect the rating of the Securities.
FF. ``Eligible Swap'' means a Ratings Dependent or Non-Ratings
Dependent Swap:
(1) Which is denominated in U.S. dollars;
(2) Pursuant to which the Issuer pays or receives, on or
immediately prior to the respective payment or distribution date for
the class of Securities to which the swap relates, a fixed rate of
interest, or a floating rate of interest based on a publicly available
index (e.g., LIBOR or the U.S. Federal Reserve's Cost of Funds Index
(COFI)), with the Issuer receiving such payments on at least a
quarterly basis and obligated to make separate payments no more
frequently than the counterparty, with all simultaneous payments being
netted;
(3) Which has a notional amount that does not exceed either: (i)
The principal balance of the class of Securities to which the swap
relates, or (ii) the portion of the principal balance of such class
represented solely by those types of corpus or assets of the Issuer
referred to in subsections III.B.(1), (2) and (3);
(4) Which is not leveraged (i.e., payments are based on the
applicable notional amount, the day count fractions, the fixed or
floating rates designated in subsection III.FF.(2), and the difference
between the products thereof, calculated on a one to one ratio and not
on a multiplier of such difference);
(5) Which has a final termination date that is either the earlier
of the date on which the Issuer terminates or the related class of
securities is fully repaid; and
(6) Which does not incorporate any provision which could cause a
unilateral alteration in any provision described in subsections
III.FF.(1) through (4) without the consent of the Trustee.
GG. ``Eligible Swap Counterparty'' means a bank or other financial
institution which has a rating, at the date of issuance of the
Securities by the Issuer, which is in one of the three highest long