[[Page 59613]]

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Part II

Department of the Treasury
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Office of the Comptroller of the Currency

Office of Thrift Supervision

12 CFR Parts 3 and 567

Federal Reserve System

12 CFR Parts 208 and 225

Federal Deposit Insurance Corporation

12 CFR Part 325

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Risk-Based Capital Guidelines; Capital Adequacy Guidelines; Capital
Maintenance: Capital Treatment of Recourse, Direct Credit Substitutes
and Residual Interests in Asset Securitizations; Final Rules

[[Page 59614]]

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DEPARTMENT OF THE TREASURY

Office of the Comptroller of the Currency

12 CFR Part 3

[Docket No. 01-24]
RIN 1557-AB14

FEDERAL RESERVE SYSTEM

12 CFR Parts 208 and 225

[Regulations H and Y; Docket No. R-1055]

FEDERAL DEPOSIT INSURANCE CORPORATION

12 CFR Part 325

RIN 3064-AB31

DEPARTMENT OF THE TREASURY

Office of Thrift Supervision

12 CFR Part 567

[Docket No. 2001-68]
RIN 1550-AB11

Risk-Based Capital Guidelines; Capital Adequacy Guidelines;
Capital Maintenance: Capital Treatment of Recourse, Direct Credit
Substitutes and Residual Interests in Asset Securitizations

AGENCIES: Office of the Comptroller of the Currency, Treasury; Board of
Governors of the Federal Reserve System; Federal Deposit Insurance
Corporation; and Office of Thrift Supervision, Treasury.

ACTION: Final rule.

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SUMMARY: The Office of the Comptroller of the Currency (OCC), the Board
of Governors of the Federal Reserve System (Board), the Federal Deposit
Insurance Corporation (FDIC), and the Office of Thrift Supervision
(OTS) (collectively, the agencies) are changing their regulatory
capital standards to address the treatment of recourse obligations,
residual interests and direct credit substitutes that expose banks,
bank holding companies, and thrifts (collectively, banking
organizations) primarily to credit risk. The final rule treats recourse
obligations and direct credit substitutes more consistently than the
agencies' current risk-based capital standards and adds new standards
for the treatment of residual interests, including a concentration
limit for credit-enhancing interest-only strips. In addition, the
agencies use credit ratings and certain alternative approaches to match
the risk-based capital requirement more closely to a banking
organization's relative risk of loss for certain positions in asset
securitizations. The final rule does not include the proposed
requirement that the sponsor of a revolving credit securitization that
involves an early amortization feature hold capital against the amount
of assets under management.
This rule is intended to result in a more consistent treatment for
similar transactions among the agencies, more consistent regulatory
capital treatment for certain transactions involving similar risk, and
capital requirements that more closely reflect a banking organization's
relative exposure to credit risk.

DATES: This rule is effective January 1, 2002. Any transactions settled
on or after January 1, 2002, are subject to this final rule. Banking
organizations that enter into transactions before January 1, 2002, may
elect early adoption, as of November 29, 2001, of any provision of the
final rule that results in a reduced capital requirement. Conversely,
banking organizations that enter into transactions before January 1,
2002, that result in increased capital requirements under the final
rule may delay the application of this rule to those transactions until
December 31, 2002.

FOR FURTHER INFORMATION CONTACT: OCC: Amrit Sekhon, Risk Expert,
Capital Policy Division, (202) 874-5211; Laura Goldman, Senior
Attorney, Legislative and Regulatory Activities Division, (202) 874-
5090, Office of the Comptroller of the Currency, 250 E Street, SW,
Washington, DC 20219.
Board: Thomas R. Boemio, Senior Supervisory Financial Analyst,
(202) 452-2982, Arleen Lustig, Supervisory Financial Analyst, (202)
452-2987, or Barbara Bouchard, Assistant Director (202) 452-3072,
Division of Banking Supervision and Regulation. For the hearing
impaired only, Telecommunication Device for the Deaf (TDD), (202) 263-
4869, Board of Governors of the Federal Reserve System, 20th Street and
Constitution Avenue, NW, Washington, DC 20551.
FDIC: Robert F. Storch, Chief, Accounting Section, Division of
Supervision, (202) 898-8906; Jason C. Cave, Senior Capital Markets
Specialist, Division of Supervision, (202) 898-3548; Miguel D. Browne,
Manager, Policy, Risk Management and Operations, Division of
Supervision, (202) 898-6789; Marc J. Goldstrom, Counsel, (202) 898-8807
or Michael B. Phillips, Counsel, (202) 898-3581, Supervision and
Legislation Branch, Legal Division, Federal Deposit Insurance
Corporation, 550 17th Street, NW, Washington, DC 20429.
OTS: Michael D. Solomon, Senior Program Manager for Capital Policy,
(202) 906-5654, David Riley, Project Manager, Supervision Policy, (202)
906-6669; Teresa Scott, Counsel (Banking and Finance), (202) 906-6478,
or Karen Osterloh, Assistant Chief Counsel, (202) 906-6639, Office of
Thrift Supervision, 1700 G Street, NW, Washington, DC 20552.

SUPPLEMENTARY INFORMATION:
I. Introduction
A. Asset Securitization
B. Residual Interests
C. The Combined Final Rule
II. Background
A. Asset Securitization
B. Risk Management of Exposures Arising from Securitization
Activities
C. Current Risk-Based Capital Treatment of Recourse, Residual
Interests and Direct Credit Substitutes
1. Recourse and Retained Residual Interests
2. Direct Credit Substitutes
3. Concerns Raised by Current Capital Treatment
III. Description of the Final Rule: Treatment of Recourse, Residual
Interests and Direct Credit Substitutes
A. The General Approach Taken in the Final Rule
1. Combined Final Rule
2. Managed Assets Capital Charge
3. Capital Charge for Residual Interests
a. Concentration Limit Capital Charge
b. Dollar-for-Dollar Capital Charge
B. Definitions and Scope of the Final Rule
1. Recourse
2. Direct Credit Substitute
3. Residual Interests
4. Credit-Enhancing Interest-Only Strips
5. Credit Derivatives
6. Credit-Enhancing Representations and Warranties
7. Clean-up Calls
8. Loan Servicing Arrangements
9. Interaction with Market Risk Rule
10. Reservation of Authority
11. Alternative Capital Calculation for Small Business
Obligations
C. Ratings-based Approach: Traded and Non-traded Positions
D. Unrated Positions
1. Use of Banking Organizations' Internal Risk Ratings
2. Ratings of Specific Positions in Structured Financing
Programs
3. Use of Qualifying Rating Software Mapped to Public Rating
Standards
IV. Effective Date of the Final Rule
V. Miscellaneous Changes
VI. Regulatory Analysis
A. Regulatory Flexibility Act
B. Paperwork Reduction Act
C. Executive Order 12866
D. Unfunded Mandates Reform Act of 1995
E. Plain Language

I. Introduction

The agencies are amending their regulatory capital standards to
change

[[Page 59615]]

the treatment of certain recourse obligations, direct credit
substitutes, residual interests and other positions in securitized
transactions that expose banking organizations to credit risk. This
final rule amends the agencies' regulatory capital standards to align
more closely the risk-based capital treatment of recourse obligations
and direct credit substitutes, to vary the capital requirements for
positions in securitized transactions (and certain other credit
exposures) according to their relative risk, and to require capital
commensurate with the risks associated with residual interests.

A. Asset Securitization

This final rule builds on the agencies' earlier work with respect
to the appropriate risk-based capital treatment for recourse
obligations and direct credit substitutes. On May 25, 1994, the
agencies published in the Federal Register a proposal to reduce the
capital requirement for low-level recourse transactions, and to treat
first-loss (but not second-loss) direct credit substitutes like
recourse. 59 FR 27116, May 25, 1994 (the 1994 Notice). The 1994 Notice
also contained, in an advance notice of proposed rulemaking, a proposal
to use credit ratings from nationally recognized statistical rating
organizations (rating agencies) to determine the capital treatment of
certain recourse obligations and direct credit substitutes. The OCC,
the Board, and the FDIC subsequently implemented the capital reduction
for low-level recourse transactions, thereby satisfying the
requirements of section 350 of the Riegle Community Development and
Regulatory Improvement Act, Pub. L. 103-325, sec. 350, 108 Stat. 2160,
2242 (1994) (CDRI Act).\1\ The OTS risk-based capital regulation
already included the low-level recourse treatment required by the
statute. The agencies did not issue a final regulation on the remaining
elements of the 1994 Notice.
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\1\ See 60 FR 17986, April 10, 1995 (OCC); 60 FR 8177, February
13, 1995 (Board); 60 FR 15858, March 28, 1995 (FDIC).
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On November 5, 1997, the agencies published another notice of
proposed rulemaking. 62 FR 59943, November 5, 1997 (1997 Proposal). In
the 1997 Proposal, the agencies proposed to use credit ratings from
rating agencies to determine the capital requirements for recourse
obligations, direct credit substitutes, and senior asset-backed
securities in asset securitizations. Additionally, the 1997 Proposal
requested comment on a series of options and alternatives to supplement
or replace the proposed ratings-based approach.
On March 8, 2000, the agencies published a third notice of proposed
rulemaking on recourse and direct credit substitutes. 65 FR 12320,
March 8, 2000 (2000 Recourse Proposal). The 2000 Recourse Proposal
built on the ratings-based approach and eliminated several options from
the 1997 Proposal, including the modified gross-up approach, the
ratings benchmark approach, and the historical losses approach. The
2000 Recourse Proposal also permitted the limited use of a banking
organization's qualifying internal risk rating system, a rating
agency's or other appropriate third party's review of the credit risk
of positions in structured programs, or qualifying software to
determine the capital requirement for certain unrated direct credit
substitutes. Finally, the 2000 Recourse Proposal required a sponsor of
a revolving credit securitization that contained an early amortization
feature to hold capital against the amount of assets under management
in that securitization.
In the international arena, the Basel Committee on Banking
Supervision (of which the OCC, the Board, and the FDIC are members)
issued a consultative paper entitled, ``A New Capital Adequacy
Framework'' in January 2001,\2\ on possible revisions to the 1988 Basel
Accord.\3\ The Basel Consultative Paper discusses potential
modifications to the current capital standards, including the capital
treatment of securitizations. The standards established by this final
rule are consistent in many respects with the Basel Consultative Paper.
In particular, the use of external credit ratings issued by rating
agencies as a basis for determining the credit quality and the
resulting capital treatment of securitizations is consistent with the
approach outlined by the Basel Committee. While the agencies believe
that it is essential to address securitizations by rule at this time,
they intend to consider additional changes to this rule when revisions
to the Basel Accord are finalized.
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\2\ The January 2001 Basel Consultative Paper amends and refines
a Consultative Paper issued in June 1999.
\3\ International Convergence of Capital Measurement and Capital
Standards (July 1988).
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B. Residual Interests

In response to the increased use of securitizations by
instititutions, the agencies published Interagency Guidance on Asset
Securitization Activities \4\ in December 1999 (Securitization
Guidance), which addresses the supervisory concerns with the risk
management and oversight of securitization programs.\5\ The
Securitization Guidance highlighted the most significant risks
associated with asset securitization, emphasized the agencies' concerns
with certain residual interests generated from the securitization and
sale of assets, and set forth fundamental risk management practices for
banking organizations that engage in securitization activities. In
addition, the Securitization Guidance stressed the need for management
to implement policies and procedures that include limits on the amount
of residual interests that may be carried as a percentage of capital.
Furthermore, the Guidance stated that, given the risks presented by
these activities, the agencies would actively consider the
establishment of regulatory restrictions that would limit or eliminate
the amount of certain residual interests that could be recognized in
determining the adequacy of regulatory capital.
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\4\ See OCC Bulletin 99-46 (December 14, 1999) (OCC); FDIC
Financial Institution Letter 109-99 (December 13, 1999) (FDIC); SR
Letter 99-37(SUP) (December 13, 1999) (Board); and CEO LTR 99-119
(December 14, 1999) (OTS).
\5\ The agencies previously considered, but declined to adopt,
capital rules imposing concentration limits on certain residual
assets, i.e., interest-only strips. See 63 FR 42668 (August 10,
1998). This 1998 rulemaking is discussed more fully at section
II.C.3. of this preamble.
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In September 2000, the agencies published a notice of proposed
rulemaking on residual interests in asset securitizations and other
transfers of financial assets. 65 FR 57993, September 27, 2000
(Residuals Proposal). The proposal more directly addressed the
agencies' concerns with residual interests, which were highlighted in
the Securitization Guidance. The Residuals Proposal defined residual
interests and proposed a deduction from Tier 1 capital \6\ for the
amount of residual interests held by a banking organization that exceed
25% of Tier 1 capital (concentration limit). The agencies further
proposed that risk-based capital be held dollar-for-dollar against the
remaining residuals (dollar-for-dollar capital charge) even if the
resulting capital charge exceeded the full risk-based capital charge
(e.g., 8%) typically held against the transferred assets that are
supported by the residual. The Residuals Proposal also permitted
banking organizations to calculate the amount of a residual ``net-of-
associated deferred tax liability'' in determining the appropriate
amount of

[[Page 59616]]

capital required. In no event would the amount of capital have exceeded
the residual interest balance.
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\6\ The OTS also uses the term ``core capital'' to describe Tier
1 capital.
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C. The Combined Final Rule

The agencies collectively received 32 comments on the 2000 Recourse
Proposal and 34 comments on the Residuals Proposal. Comments were
received from banks and thrifts, law and accounting firms, trade
associations, and government-sponsored enterprises. Commenters
generally favored the ratings-based approach proposed in the 2000
Recourse Proposal, but were concerned about the increased capital
requirements outlined for residuals in the Residuals Proposal.
The two proposals overlap in scope in that both address leveraged
credit risk. As many commenters noted, for certain positions the
Residuals Proposal required capital treatment that differed from that
required under the 2000 Recourse Proposal. Recognizing the overlap and
interaction between the two proposals, the agencies have developed a
single final rule that combines aspects of the Residuals Proposal and
the 2000 Recourse Proposal.

II. Background

A. Asset Securitization

Asset securitization is the process by which loans or other credit
exposures are pooled and reconstituted into securities, with one or
more classes or positions, that may then be sold. Securitization \7\
provides an efficient mechanism for banking organizations to buy and
sell loan assets or credit exposures and thereby to increase the
organization's liquidity.
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\7\ For purposes of this discussion, references to
``securitization'' also include structured finance transactions or
programs and synthetic transactions that generally create stratified
credit risk positions, which may or may not be in the form of a
security, whose performance is dependent upon a pool of loans or
other credit exposures. Synthetic transactions bundle credit risks
associated with on-balance sheet assets and off-balance sheet items
and resell them into the market. For examples of synthetic
securitization structures, see Banking Bulletin 99-43, November 15,
1999 (OCC); SR Letter 99-32, Capital Treatment for Synthetic CLOs,
November 17, 1999 (Board).
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Securitizations typically carve up the risk of credit losses from
the underlying assets and distribute it to different parties. The
``first dollar,'' or most subordinate, loss position is first to absorb
credit losses; the most ``senior'' investor position is last to absorb
losses; and there may be one or more loss positions in between
(``second dollar'' loss positions). Each loss position functions as a
credit enhancement for the more senior positions in the structure.
For residential mortgages sold through certain Federally-sponsored
mortgage programs, a Federal government agency or Federal government-
sponsored enterprise (GSE) guarantees the securities sold to investors
and may assume the credit risk on the underlying mortgages. However,
many of today's asset securitization programs involve assets that are
not Federally supported in any way. Sellers of these privately
securitized assets therefore often provide other forms of credit
enhancement--that is, they take first or second dollar loss positions--
to reduce investors' credit risk.
A seller may provide this credit enhancement itself through
recourse arrangements. The agencies use the term ``recourse'' to refer
to the credit risk that a banking organization retains in connection
with the transfer of its assets. Banking organizations have long
provided recourse in connection with sales of whole loans or loan
participations; today, recourse arrangements frequently are also
associated with asset securitization programs. Depending on the type of
securitization transaction, the sponsor of a securitization may provide
a portion of the total credit enhancement internally, as part of the
securitization structure, through the use of excess spread accounts,
overcollateralization, retained subordinated interests, or other
similar on-balance sheet assets. When these or other on-balance sheet
internal enhancements are provided, the enhancements are ``residual
interests'' for regulatory capital purposes. Such residual interests
are a form of recourse.
A seller may also arrange for a third party to provide credit
enhancement \8\ in an asset securitization. If the third-party
enhancement is provided by another banking organization, that
organization assumes some portion of the assets' credit risk. In this
final rule, all forms of third-party enhancements, i.e., all
arrangements in which a banking organization assumes credit risk from
third-party assets or other claims that it has not transferred, are
referred to as ``direct credit substitutes.'' \9\ The economic
substance of a banking organization's credit risk from providing a
direct credit substitute can be identical to its credit risk from
retaining recourse on assets it has transferred.
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\8\ As used in this final rule, the terms ``credit enhancement''
and ``enhancement'' refer to both recourse arrangements, including
residual interests, and direct credit substitutes.
\9\ For purposes of this rule, purchased credit-enhancing
interest-only strips are also ``residual interests.''
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Many asset securitizations use a combination of recourse and third-
party enhancements to protect investors from credit risk. When third-
party enhancements are not provided, the selling banking organization
ordinarily retains virtually all of the credit risk on the assets
transferred.

B. Risk Management of Exposures Arising From Securitization Activities

While asset securitization can enhance both credit availability and
a banking organization's profitability, managing the risks associated
with this activity can pose significant challenges. The risks involved,
while not new to banking organizations, may be less obvious and more
complex than the risks of traditional lending. Specifically,
securitization can involve credit, liquidity, operational, legal, and
reputational risks in concentrations and forms that may not be fully
recognized by management or adequately incorporated into a banking
organization's risk management systems.
The capital treatment required by the final rule provides one
important way of addressing the credit risk presented by securitization
activities. However, a banking organization's compliance with capital
standards should be complemented by effective risk management
strategies. The agencies expect that banking organizations will
identify, measure, monitor and control the risks of their
securitization activities (including synthetic securitizations using
credit derivatives) and explicitly incorporate the full range of risks
into their risk management systems. Management is responsible for
having adequate policies and procedures in place to ensure that the
economic substance of their risks is fully recognized and appropriately
managed. Banking organizations should be able to measure and manage
their risk exposure from risk positions in the securitizations, either
retained or acquired, and should be able to assess the credit quality
of any retained residual portfolio. The formality and sophistication
with which the risks of these activities are incorporated into a
banking organization's risk management system should be commensurate
with the nature and volume of its securitization activities. Banking
organizations with significant securitization activities, no matter
what the size of their on-balance sheet assets, are expected to have
more advanced and formal approaches to manage the risks.
The Securitization Guidance addresses the fundamental risk
management practices that should be in

[[Page 59617]]

place at banking organizations that engage in securitization
activities. The Guidance stresses the need for management to implement
policies and procedures that include limits on the amount of residual
interests that may be carried as a percentage of capital. Moreover, the
Securitization Guidance sets forth the supervisory expectation that the
value of a residual interest in a securitization must be supported by
objectively verifiable documentation of the asset's fair market value
using reasonable, conservative valuation assumptions. Residual
interests that do not meet this expectation, or that fail to meet the
supervisory standards set forth in the Securitization Guidance, should
be classified as ``loss'' and disallowed as assets of the banking
organization for regulatory capital purposes.
Moreover, the agencies indicated in the Securitization Guidance
that banking organizations found to be lacking effective risk
management programs or engaging in practices that present safety and
soundness concerns will be subject to more frequent supervisory review,
limitations on residual interest holdings, more stringent capital
requirements, or other supervisory response. Thus, failure to
understand the risks inherent in securitization activities and to
incorporate them into risk management systems and internal capital
allocations may constitute an unsafe or unsound banking practice and
may result in a downgrading of a banking organization's CAMELS or BOPEC
\10\ rating.
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\10\ CAMELS is the acronym for the supervisory rating assigned
to banks and thrifts. It measures Capital, Asset quality,
Management, Earnings, Liquidity and Sensitivity to market risk.
BOPEC is the acronym for the supervisory rating assigned to bank
holding companies. It measures performance of Banking subsidiaries,
Other subsidiaries, the Parent holding company, Earnings and
Capital.
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C. Current Risk-Based Capital Treatment of Recourse, Residual Interests
and Direct Credit Substitutes

Currently, the agencies' risk-based capital standards apply
different treatments to recourse obligations, including residual
interests, and direct credit substitutes. As a result, capital
requirements applicable to credit enhancements do not consistently
reflect credit risk, even though the risk characteristics are similar.
The current rules of the OCC, Board, and FDIC (the banking agencies)
are also not entirely consistent with those of the OTS. One objective
of the final rule is to remove or reduce these inconsistencies.
1. Recourse and Retained Residual Interests
The agencies' risk-based capital guidelines prescribe a single
treatment for assets transferred with recourse (including retained
residual interests), regardless of whether the transaction is reported
as a sale of assets or as a financing in a bank's Consolidated Report
of Condition and Income (Call Report), a bank holding company's FR Y-9
reports, or a thrift's Thrift Financial Report. For a transaction
reported as a financing, the transferred assets remain on the balance
sheet and are risk-weighted. For a transaction reported as a sale, the
entire outstanding amount of the assets sold with recourse (not just
the contractual amount of the recourse obligation) is converted into an
on-balance sheet credit equivalent amount using a 100% credit
conversion factor. This credit equivalent amount (less any applicable
recourse liability account recorded on the balance sheet) is then risk-
weighted.\11\ If the seller's balance sheet includes as an asset (other
than a servicing asset) any interest that acts as a credit enhancement
to the assets sold, that interest is not risk-weighted a second time as
an on-balance sheet item. Thus, regardless of the method used to
account for the transfer, risk-based capital is held against the full,
risk-weighted amount of the assets transferred with recourse, unless
the transaction is subject to the low-level recourse rule.\12\
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\11\ Consistent with statutory requirements, the agencies'
current rules also provide for special treatment of sales of small
business obligations with recourse. See 12 CFR part 3, appendix A,
Section 3(c) (OCC); 12 CFR parts 208 and 225, appendix A, II.B.5
(FRB); 12 CFR part 325, appendix A, II.B.6 (FDIC); 12 CFR
567.6(a)(3) (OTS). See also discussion in section III.B.11 of this
preamble.
\12\ Section 350 of the CDRI Act required the agencies to
prescribe regulations providing that the risk-based capital
requirement for assets transferred with recourse could not exceed a
banking organization's maximum contractual exposure. The agencies
may require a higher amount if necessary for safety and soundness
reasons. See 12 U.S.C. 4808.
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The low-level recourse rule limits the maximum risk-based capital
requirement to the lesser of the banking organization's maximum
contractual exposure or the full capital charge against the outstanding
amount of assets transferred with recourse. When the low-level recourse
rule applies, a banking organization generally holds capital on a
dollar-for-dollar basis against the amount of its maximum contractual
exposure. In the absence of any other recourse provisions, the on-
balance sheet amount of a residual interest represents the maximum
contractual exposure. For example, assume that a banking organization
securitizes $100 million of credit card loans and records a residual
interest on the balance sheet of $5 million that serves as a credit
enhancement for the assets transferred. Before the low-level recourse
rule was issued, the banking organization was required to hold $8
million of risk-based capital against the $100 million in loans sold,
as though the loans had not been sold. Under the low-level recourse
rule, the banking organization is required to hold $5 million in
capital, that is, ``dollar-for-dollar'' capital up to the banking
organization's maximum contractual exposure. However, if the banking
organization has recorded a residual interest of $10 million (rather
than $5 million), the low-level recourse rule would not have applied.
The banking organization would have been required to hold the full
capital charge, i.e., $8 million in this example, even though its
maximum contractual exposure was $10 million.
For leverage capital ratio purposes, if a transfer with recourse is
reported as a financing, the transferred assets remain on the
transferring banking organization's balance sheet and the banking
organization must hold leverage capital against these assets. If a
transfer with recourse is reported as a sale, the assets sold do not
remain on the selling banking organization's balance sheet and the
banking organization need not hold leverage capital against these
assets. However, because certain recourse obligations (e.g., retained
residual interests) are recorded as an asset on the seller's balance
sheet, leverage capital must be held against those obligations.
2. Direct Credit Substitutes
Direct credit substitutes are treated differently from recourse
obligations under the existing risk-based capital standards. Currently,
off-balance sheet direct credit substitutes, such as financial standby
letters of credit provided for third-party assets, carry a 100% credit
conversion factor. However, only the face amount of the direct credit
substitute is converted into an on-balance sheet credit equivalent
amount. As a result, capital is held only against the face amount of
the direct credit substitute. The capital requirement for a recourse
arrangement, in contrast, generally is based on the full amount of the
assets enhanced.
If a direct credit substitute covers less than 100% of the
potential losses on the assets enhanced, the current capital treatment
results in a lower capital charge for a direct credit substitute than
for a comparable recourse arrangement

[[Page 59618]]

even though the economic risk of loss is similar. For example, if a
direct credit substitute covers losses up to the first 20% of $100 of
enhanced assets, then the on-balance sheet credit equivalent amount
equals $20, and risk-based capital is held against only the $20 amount.
In contrast, required capital for a first-loss 20% recourse arrangement
on $100 of transferred assets is higher because capital is held against
the entire $100 of the assets enhanced.
Currently, under the banking agencies' risk-based capital
guidelines, purchased subordinated interests receive the same capital
treatment as off-balance sheet direct credit substitutes; that is, only
the dollar amount of the purchased subordinated interest is placed in
the appropriate risk-weight category. In contrast, a banking
organization that retains a subordinated interest in connection with
the transfer of its own assets is considered to have transferred the
assets with recourse, even though the economic and credit risks are
similar. As a result, the banking organization must hold capital
against the carrying amount of the retained subordinated interest as
well as the outstanding dollar amount of all senior interests that it
supports, subject to the low-level recourse rule.
The OTS risk-based capital regulation treats some forms of direct
credit substitutes (e.g., financial standby letters of credit) in the
same manner as the banking agencies' guidelines. However, unlike the
banking agencies, the OTS treats purchased subordinated interests
(except for certain high quality subordinated mortgage-related
securities) under its general recourse provisions. The risk-based
capital requirement is based on the carrying amount of the subordinated
interest plus all senior interests, as though the thrift owned the full
outstanding amount of the assets enhanced.
3. Concerns Raised by Current Capital Treatment
The agencies' current leverage and risk-based capital standards
raise significant concerns with respect to the treatment of recourse
and direct credit substitutes. First, banking organizations are often
required to hold different amounts of capital for recourse arrangements
and direct credit substitutes that expose the banking organization to
similar credit risks. Banking organizations are taking advantage of
this anomaly, for example, by taking first-loss positions through
financial standby letters of credit, i.e., direct credit substitutes,
in asset-backed commercial paper conduits that lend directly to
corporate customers. These direct credit substitutes are accorded a
significantly lower capital requirement than if a banking organization
were to retain a subordinated position in a securitization comprised of
loans that had originally been carried on its balance sheet, i.e. a
recourse obligation, notwithstanding that the credit risks of both
positions are virtually the same. Moreover, the current capital
standards do not recognize differences in risk associated with
different loss positions in asset securitizations, nor do they provide
uniform definitions of recourse, residual interest, direct credit
substitute, and associated terms.
Residual interests, including retained or purchased credit-
enhancing interest-only strips (credit-enhancing I/Os), raise further
supervisory concerns. Fair value is the basis for the initial
measurement and, in most cases, the ongoing measurement of residual
interests on banking organizations' balance sheets. In addition,
declines in fair value trigger determinations as to whether other than
temporary impairments of residual interests should be recognized.
Banking organizations' fair value estimates for these instruments,
however, are often based on unwarranted assumptions about expected
future cash flows. No active market exists for many residual interests,
including credit-enhancing I/Os. As a result, there is no marketplace
from which an arm's length market price can readily be obtained to
support the residual interest valuation. Recent examinations have
highlighted the inherent uncertainty and volatility regarding the
initial and ongoing valuation of credit-enhancing I/Os and other
residual interests. A banking organization that securitizes assets may
overvalue its residual interests, including its credit-enhancing I/Os,
and thereby inappropriately generate ``paper profits'' (or mask actual
losses) through incorrect cash flow modeling, flawed loss assumptions,
inaccurate prepayment estimates, and inappropriate discount rates. This
often leads to an inflation of capital, making the banking organization
appear more financially sound than it is. Embedded within residual
interests, including credit-enhancing I/Os, is a significant level of
credit and prepayment risk that make their valuation extremely
sensitive to changes in underlying assumptions. Market events can
affect the discount rate, prepayment speed or performance of the
underlying assets in a securitization transaction and can swiftly and
dramatically alter their value. A banking organization that holds an
excessive concentration of residual interests in relation to capital
presents significant safety and soundness concerns.
Existing regulatory capital rules do not adequately reflect the
risks associated with residual interests. Often, banking organizations
that securitize and sell higher risk assets are required to retain a
large residual interest (often greater than the full capital charge of
8 percent on 100 percent risk-weighted assets) to ensure that the more
senior positions in the securitization or other asset sale can receive
the desired investment ratings. The booking of a residual interest
using gain-on-sale accounting can increase the selling banking
organization's capital and thereby allow the banking organization to
leverage the capital created from the securitization. This creation of
capital is most commonly associated with credit-enhancing I/Os and
other spread-related assets. Write-downs of the recorded value of the
residual interest due to changes in assumptions concerning loss,
prepayment or discount rates can subsequently result in losses. Any
losses in excess of the full capital charge (8 percent in the example
above) will negatively affect the capital adequacy of the banking
organization and, thereby, its safety and soundness.
Moreover, the current capital rules also do not subject either
purchased or retained credit-enhancing I/Os to a concentration limit.
In 1998, the agencies amended their capital rules to impose strict
limits on the amount of nonmortgage servicing assets that may be
included in Tier 1 capital.\13\ These strict limitations were imposed
due to the lack of depth and maturity of the marketplace for such
assets, and related concerns about their valuation, liquidity, and
volatility.
---------------------------------------------------------------------------

\13\ See 63 FR 42688 August 10, 1998.
---------------------------------------------------------------------------

The agencies, however, considered but declined to adopt similar
concentration limits for I/O strips in that 1998 rulemaking,
notwithstanding that certain I/O strips possessed cash flow
characteristics similar to servicing assets and presented similar
valuation, liquidity, and volatility concerns. The agencies chose not
to impose such a limitation in recognition of the ``prudential effects
of banking organizations relying on their own risk assessment and
valuation tools, particularly their interest rate risk, market risk,
and other analytical models.'' \14\ The agencies expressly indicated
that they would continue to review banking organizations' valuation of
I/O strips and the concentrations of these assets relative to capital.

[[Page 59619]]

Moreover, the agencies noted that they ``may, on a case-by-case basis,
require banking organizations that the agencies determine have high
concentrations of these assets relative to their capital, or are
otherwise at risk from these assets, to hold additional capital
commensurate with their risk exposures.'' \15\
---------------------------------------------------------------------------

\14\ Id. at 42672.
\15\ Id.
---------------------------------------------------------------------------

When the servicing assets final rule was issued in 1998, most I/O
strips used as credit enhancements did not exceed the full-capital
charge on the transferred assets. However, the securitization of higher
risk loans has resulted in residual interests, such as credit-enhancing
I/O strips, that exceed the full-capital charge. In addition, certain
banking organizations engaged in such securitization transactions have
significant concentrations in highly volatile credit-enhancing I/Os as
a percentage of capital.

III. Description of the Final Rule: Treatment of Recourse, Residual
Interests and Direct Credit Substitutes

This final rule amends the agencies' regulatory capital standards
as follows:
It defines the terms ``recourse,'' ``residual interest''
and related terms and revises the definition of ``direct credit
substitute'';
It provides more consistent risk-based capital treatment
for recourse obligations and direct credit substitutes;
It varies the capital requirements for positions in
securitization transactions according to their relative risk exposure,
using credit ratings from rating agencies to measure the level of risk;
It permits the limited use of a banking organization's
qualifying internal risk rating system to determine the capital
requirement for certain unrated direct credit substitutes;
It permits the limited use of a rating agency's review of
the credit risk of positions in structured programs and qualifying
software to determine the capital requirement for certain unrated
direct credit substitutes and recourse exposures (but not residual
interests);
It requires a banking organization to deduct credit-
enhancing interest-only strips, whether retained or purchased, that are
in excess of 25% of Tier 1 capital from Tier 1 capital and from assets
(concentration limit);
It requires a banking organization to maintain risk-based
capital in an amount equal to the face amount of a residual interest
that does not qualify for the ratings-based approach (including credit-
enhancing interest-only strips that have not been deducted from Tier 1
capital) (dollar-for-dollar capital); and
It permits each agency to modify a stated risk-weight,
credit conversion factor or credit equivalent amount, if warranted, on
a case-by-case basis.
The agencies intend to apply this final rule to the substance,
rather than the form, of a securitization transaction. Regulatory
capital will be assessed based on the risks inherent in a position
within a securitization, regardless of its characterization.

A. The General Approach Taken in the Final Rule

1. Combined Final Rule
As noted above, this final rule harmonizes the proposed capital
treatment for residuals with the broader capital treatment for recourse
and direct credit substitutes. It also permits the use of ratings to
match the risk-based capital requirement more closely to the relative
risk of loss in asset securitizations (see discussion below at section
III.C.). Highly rated investment-grade positions in securitizations
receive a favorable (less than 100 percent) risk-weight. Below-
investment grade or unrated positions in securitizations would receive
a less favorable risk-weight (generally greater than 100 percent risk-
weight). A residual interest retained by a banking organization in an
asset securitization (other than a credit-enhancing I/O strip) would be
subject to this capital framework. Therefore, if the external rating
provided to such a residual interest is investment grade or no more
than one category below investment grade, the final rule affords that
residual interest more favorable capital treatment than the dollar-for-
dollar capital requirement otherwise required for residuals (see
discussion below in section III.C.).
2. Managed Assets Capital Charge
The 2000 Recourse Proposal proposed to assess a risk-based capital
charge on sponsors of revolving credit securitizations that contain an
early amortization feature (managed assets capital charge). All
commenters that addressed the managed assets issue opposed the adoption
of such a capital charge. Commenters noted that the risks the managed
assets capital charge is meant to address (e.g., liquidity risk and
credit risk) are not unique to securitizations with early amortization
features. Several commenters observed that liquidity risk exists in
varying degrees in every banking organization, and implicit recourse
arises any time that a banking organization securitizes assets.
Commenters also noted that a banking organization faces the credit risk
associated with future receivables resulting from revolving loan
commitments even if the banking organization is not involved in
securitization.
For these reasons, the agencies have agreed at this time not to
assess risk-based capital against securitized off-balance sheet assets
in revolving securitizations incorporating early amortization
provisions. The agencies strongly believe, however, that the risks
associated with securitization, including those posed by an early
amortization feature, are not fully captured in current regulatory
capital rules and need to be addressed. Therefore, the agencies plan to
make a more comprehensive assessment of the risks to a selling banking
organization posed by the securitization process, including the risks
arising from early-amortization features, implicit recourse
arrangements and non-credit risks. The agencies have not, as yet,
determined whether they will issue a proposed capital rule or
supervisory guidance on this matter.
3. Capital Charge for Residual Interests
The final rule imposes a ``dollar-for-dollar'' capital charge on
residual interests and a concentration limit on a subset of residual
interests--credit-enhancing I/O strips.\16\ Under the combined
approach, credit-enhancing I/O strips are limited to 25% of Tier 1
capital. Everything above that amount will be deducted from Tier 1
capital. Generally, all other residual interests that do not qualify
for the ratings-based approach (including any credit-enhancing I/O
strips that were not deducted from Tier 1 capital) are subject to a
dollar-for-dollar capital charge. In no event will this combined
capital charge exceed the face amount of a banking organization's
residual interests.
---------------------------------------------------------------------------

\16\ The definitions of residual interests and credit-enhancing
I/Os are discussed in Sections III.B.3 and 4, below.
---------------------------------------------------------------------------

a. Concentration Limit Capital Charge. The final rule imposes a
concentration limit on a subset of residual interests. It limits the
inclusion of interest-only strips that serve in a credit-enhancing
capacity (credit-enhancing I/O strips), whether retained or purchased,
to 25% of Tier 1 capital for regulatory capital purposes (see
discussion below at III.B.4).
For regulatory capital purposes only, any amount of credit-
enhancing I/O strips that exceeds the 25% limit will be deducted from
Tier 1 capital and from assets. Credit-enhancing I/O strips that are
not deducted from Tier 1 capital, along with all other residual
interests not subject to the concentration limit are

[[Page 59620]]

subject to the dollar-for-dollar capital requirement (as described
below). In calculating the capital requirement in this manner, banking
organizations will not be required to hold capital for more than 100%
of the amount of the residual interest. The following example
illustrates the concentration calculation required for banking
organizations that hold credit-enhancing I/O strips:
A banking organization has purchased and retained credit-enhancing
I/O strips with a face amount of $100 on its balance sheet and Tier 1
capital of $320 (before any disallowed servicing assets, disallowed
purchased credit card relationships, disallowed credit-enhancing I/O
strips and disallowed deferred tax assets). To determine the amount of
credit-enhancing I/O strips that fall within the concentration limit,
the banking organization would multiply the Tier 1 capital of $320 by
25%, which is $80. The amount of credit-enhancing I/O strips that
exceed the concentration limit, in this case $20, is deducted from Tier
1 capital and from assets. For risk-based capital purposes (but not for
leverage capital purposes), the remaining $80 is then subject to the
dollar-for-dollar capital charge, which is discussed below.
Of those organizations commenting on the proposed concentration
limit, most believed that a concentration limit should not be included
in the final rule. However, the narrower concentration limit is
consistent with commenters' suggestions that only interest-only strips
be included in this limit. Moreover, credit-enhancing I/O strips are
not aggregated with any servicing assets or purchased credit card
relationships for purposes of calculating the 25% concentration limit.
In that respect, the concentration limit in the final rule is a less
binding constraint than the proposed limit.
The agencies narrowed the scope of assets subject to the
concentration limit to credit-enhancing interest-only strips in
recognition of the fact that these assets generally serve in a first
loss capacity and are typically the most vulnerable to significant
write-downs due to changes in valuation assumptions. In addition,
interest-only strips are the asset type most often associated with the
creation of capital as a result of gain-on-sale accounting, which
allows a banking organization to leverage the capital created based on
the current recognition of uncertain future cash flows.
b. Dollar-for-Dollar Capital Charge. For risk-based capital
purposes (but not for leverage capital purposes), all residual
interests that do not qualify for the ratings-based approach (including
retained and purchased credit-enhancing I/O strips that have not been
deducted from Tier 1 capital) are assessed a dollar-for-dollar capital
charge. This charge requires that banking organizations hold a dollar
in capital for every dollar in residual interests, even if this capital
requirement exceeds the full risk-based capital charge on the assets
transferred. The agencies believe that the current limited capital
requirement could, in certain instances, be insufficient given the risk
inherent in large residual interest positions. Because these assets are
a subordinated interest in the future cash flows of the securitized
assets, they have a concentration of credit and prepayment risk that,
depending upon the life of the underlying asset, makes them vulnerable
to sudden and sizeable impairment. In addition, when given accounting
recognition, certain residuals, such as retained credit-enhancing I/O
strips, have the effect of creating capital, which may not be available
to support these assets if write-downs become necessary. Recent
experience has shown that residual interests can be among the riskiest
assets on the balance sheet and, therefore, most deserving of a higher
capital charge.
Continuing the above illustration for credit-enhancing I/O strips,
once a banking organization deducts the $20 in disallowed credit-
enhancing I/O strips, it must hold $80 in total capital for the $80
that represents the credit-enhancing I/O strips not deducted from Tier
1 capital. The $20 deducted from Tier 1 capital, plus the $80 in total
risk-based capital required under the dollar-for-dollar treatment,
equals $100, the face amount of the credit-enhancing I/O strips.
Banking organizations may apply a net-of-tax approach to any credit-
enhancing I/O strips that have been deducted from Tier 1 capital, as
well as to the remaining residual interests subject to the dollar-for-
dollar treatment. This calculation is illustrated in the preamble of
the Residuals Proposal at 65 FR 57998. Under this method, a banking
organization is permitted, but not required, to net the deferred tax
liabilities recorded on its balance sheet, if any, that are associated
with the residual interests. This may result in a banking organization
holding less than 100% capital against residual interests.
Several commenters on the Residuals Proposal opposed the proposed
capital treatment, believing that concerns associated with residual
interests should be handled on a case-by-case basis under the agencies'
existing supervisory authority. These commenters often referred to the
Securitization Guidance, which highlights the supervisory concerns
associated with residual interests.
The agencies believe that a minimum capital standard that more
closely aligns capital with risk, along with supervisory review, is the
appropriate course of action in dealing with residual interests. The
agencies remain concerned with the credit risk exposure associated with
these deeply subordinated assets, particularly subinvestment grade and
unrated residual interests. The lack of an active market makes these
assets difficult to value and relatively illiquid.
Most commenters considered the dollar-for-dollar risk-based capital
treatment to be overly broad and too harsh, particularly when applied
to higher quality residual interests. Commenters also were concerned
that the proposed treatment could increase the capital requirement for
a residual interest above the capital requirement for the transferred
assets when they were held on the banking organization's balance sheet.
The agencies have revised the Residuals Proposal in response to
some of the industry's concerns. The agencies understand that the
dollar-for-dollar capital requirement could result in a banking
organization holding more capital on residual interests than on the
underlying assets had they not been sold. However, in many cases the
relative size of the retained exposure by the originating banking
organization reveals additional market information about the quality of
the securitized asset pool. To facilitate a transaction in a manner
that meets with market acceptance, the securitization sponsor will
often increase the size of the residual. This practice is often
indicative of the quality of the underlying assets in the pool. In
other words, large residual positions often signal the lower credit
quality of the sold assets. Further, a banking organization's use of
gain-on-sale accounting affords it the opportunity to create capital,
the amount of which is related to a residual interest that may not be
worth its reported carrying value. Thus, to mitigate the effects of
these gains, the final rule requires banks to hold dollar-for-dollar
capital against the related assets.
Commenters suggested several alternative capital treatments such as
using the ratings based approach presented in the 2000 Recourse
Proposal to set capital requirements for residual interests, excluding
certain types of assets from the dollar-for-dollar treatment, and
revising the existing capital treatment by requiring additional

[[Page 59621]]

capital only against the gain-on-sale ``asset.'' Other commenters
proposed to limit the maximum capital requirement to the full capital
charge plus any gain-on-sale amount.
The agencies have decided not to alter the dollar-for-dollar
capital charge for residual interests that are unrated or rated B or
below, although certain residual interests rated BB or better will be
eligible for the ratings-based approach.\17\ Certain types of assets
were not excluded from the definition of ``residual interest'' because
every residual reflects a concentration of credit risk and is,
therefore, subject to valuation concerns associated with estimating
future losses. Further, gain-on-sale accounting, while a concern, was
not the only criterion in the agencies' determination of a suitable
method for calculating the capital charge for residual interests.
Basing the capital charge on the gain-on-sale amount would have made
the rule more complex, and would not necessarily result in the
maintenance of adequate capital for a residual interest since the gain-
on-sale amount can be significantly less than the carrying value of the
residual.
---------------------------------------------------------------------------

\17\ Credit-enhancing I/Os are not eligible for the ratings-
based approach.
---------------------------------------------------------------------------

B. Definitions and Scope of the Final Rule

1. Recourse
The final rule defines the term ``recourse'' to mean an arrangement
in which a banking organization retains, in form or in substance, the
credit risk in connection with an asset sale in accordance with
generally accepted accounting principles, if the credit risk exceeds a
pro rata share of the banking organization's claim on the assets. The
definition of recourse is consistent with the banking agencies'
longstanding use of this term, and incorporates existing agency
practices regarding retention of risk in asset sales.
Currently, the term ``recourse'' is not defined explicitly in the
banking agencies' risk-based capital guidelines. Instead, the
guidelines use the term ``sale of assets with recourse,'' which is
defined by reference to the Call Report Instructions. See Call Report
Instructions, Glossary (entry for ``Sales of Assets for Risk-Based
Capital Purposes''). With the adoption of a definition for recourse in
the final rule, the cross-reference to the Call Report instructions in
the guidelines is no longer necessary and has been removed. The OTS
capital regulation currently provides a definition of the term
``recourse,'' which has also been revised.
Several commenters sought clarification as to whether second lien
positions constitute recourse. While second liens are subordinate to
first liens, the agencies believe that second liens will not, in most
instances, constitute recourse. Second mortgages or home equity loans
generally will not be considered recourse arrangements unless they
actually function as credit enhancements.
Commenters also requested clarification that third-party
enhancements, e.g. insurance protection, purchased by the originator of
a securitization for the benefit of investors do not constitute
recourse. The agencies generally agree. The purchase of enhancements
for a securitization, where the banking organization is completely
removed from any credit risk will not, in most instances, constitute
recourse. However, if the purchase or premium price is paid over time
and the size of the payment is a function of the third-party's loss
experience on the portfolio, such an arrangement indicates an
assumption of credit risk and would be considered recourse.
2. Direct Credit Substitute
The definition of ``direct credit substitute'' complements the
definition of recourse. The term ``direct credit substitute'' refers to
an arrangement in which a banking organization assumes, in form or in
substance, credit risk associated with an on- or off-balance sheet
asset or exposure that was not previously owned by the banking
organization (third-party asset) and the risk assumed by the banking
organization exceeds the pro rata share of the banking organization's
interest in the third-party asset. As revised, it also explicitly
includes items such as purchased subordinated interests, agreements to
cover credit losses that arise from purchased loan servicing rights,
credit derivatives and lines of credit that provide credit enhancement.
Some purchased subordinated interests, such as credit-enhancing I/O
strips, are also residual interests for regulatory capital purposes
(see discussion in section III.B.4).
3. Residual Interests
The agencies define residual interests in the final rule as any on-
balance sheet asset that represents an interest (including a beneficial
interest) created by a transfer that qualifies as a sale (in accordance
with generally accepted accounting principles) of financial assets,
whether through a securitization or otherwise, and that exposes a
banking organization to any credit risk directly or indirectly
associated with the transferred asset that exceeds a pro rata share of
that banking organization's claim on the asset, whether through
subordination provisions or other credit enhancement techniques.
Residual interests do not include interests purchased from a third
party, except for credit-enhancing interest-only strips. Examples of
these types of assets include credit-enhancing interest-only strips
receivable; spread accounts; cash collateral accounts; retained
subordinated interests; accrued but uncollected interest on transferred
assets that, when collected, will be available to serve in a credit-
enhancing capacity; and similar on-balance sheet assets that function
as a credit enhancement. The functional-based definition reflects the
fact that securitization structures vary in the way they use certain
assets as credit enhancements. Therefore, residual interests include
any retained on-balance sheet asset that functions as a credit
enhancement in a securitization, regardless of how a banking
organization refers to the asset in its financial or regulatory
reports. In addition, due to their similar risk profile, purchased
credit-enhancing I/O strips are residual interests for regulatory
capital purposes.
Some commenters thought that the definition of residual interest
was too broad and captured assets that are not subject to valuation
concerns. The agencies have considered these comments and, as a result,
have refined the definition of residual interest in the final rule. In
general, the definition of residual interests includes only an on-
balance sheet asset that represents an interest created by a transfer
of financial assets treated as a sale under GAAP. Interests retained in
a securitization or transfer of assets accounted for as a financing
under GAAP are generally excluded from the residual interest definition
and capital treatment. In the case of GAAP financings, the transferred
assets remain on the transferring banking organization's balance sheet
and are, therefore, directly included in both the leverage and risk-
based capital calculations. Further, when a transaction is treated as a
financing, no gain is recognized from an accounting standpoint, which
serves to mitigate some of the agencies' concerns. The agencies,
however, will monitor securitization transactions that are accounted
for as financings under GAAP and will factor into the banking
organization's capital adequacy

[[Page 59622]]

determination the risk exposures being assumed or retained in
connection with a securitization transaction.
Some commenters stated that sellers' interests should not
constitute residual interests because they do not involve a
subordinated interest in a stream of cash flows, but rather a pro-rata
interest. The agencies agree that sellers' interests generally do not
function as a credit enhancement and should not be captured by the
rule. Thus, if a seller's interest shares losses on a pro rata basis
with investors, such an interest would not be a residual interest for
purposes of the rule. However, banking organizations should recognize
that sellers' interests that are structured to absorb a
disproportionate share of losses will be residual interests and subject
to the capital treatment described in the final rule.
Other commenters suggested that overcollateralization accounts are
not residual interests because the banking organization does not suffer
a potential loss from the assets transferred. They argue that certain
residual interests, such as interest-only strips, are subject to
valuation concerns that might lead to losses. However, other assets,
such as overcollateralization or spread accounts, do not present the
same level of valuation concerns and, therefore, should not be included
in the definition of residual interest.
Overcollateralization and spread accounts are susceptible to the
potential future credit losses within the loan pools that they support
and, thus, are subject to valuation inaccuracies. Further, the agencies
do not want to encourage arbitrage of the final rule by affording
banking organizations the opportunity to retain a subordinated position
in an asset labeled ``overcollateralization'' when that asset
represents the same level of credit risk as another residual interest,
just otherwise named. As a result, the definition of residual interest
continues to include overcollateralization. The agencies agree that
spread accounts and overcollateralization that do not meet the
definition of credit-enhancing interest-only strips generally do not
expose a banking organization to the same level of risk as credit-
enhancing interest-only strips, and thus, have excluded them from the
concentration limit. The agencies also believe that where a banking
organization provides additional loans to a securitization at
inception, but does not book as an asset a beneficial interest for the
present value of the future cash flows from these loans, the mere
contribution of excess assets, although it constitutes a credit
enhancement, will not constitute a residual interest under the final
rule because the banking organization has no on-balance sheet asset
that is susceptible to a write-down.
The capital treatment designated for a residual interest will apply
when a banking organization effectively retains the risk associated
with that residual interest, even if the residual is sold. The agencies
intend to look to the economic substance of the transaction to
determine whether the banking organization has transferred the risk
associated with the residual interest exposure. Banking organizations
that transfer the risk on residual interests, either directly through a
sale, or indirectly through guarantees or other credit risk mitigation
techniques, and then reassume this risk in any form will be required to
hold risk-based capital as though the residual interest remained on the
banking organization's books. For example, if a banking organization
sells an asset that is an on-balance sheet credit enhancement to a
third party and then writes a credit derivative to cover the credit
risk associated with that asset, the selling banking organization must
continue to risk weight, and hold capital against, that asset as a
residual as if the asset had not been sold.
4. Credit-Enhancing Interest-Only Strips
A credit-enhancing I/O strip is defined in the final rule as ``an
on-balance sheet asset that, in form or in substance, (i) represents
the contractual right to receive some or all of the interest due on
transferred assets; and (ii) exposes the banking organization to credit
risk that exceeds its pro rata claim on the underlying assets whether
through subordination provisions or other credit enhancing
techniques.'' Thus, credit-enhancing I/O strips include any balance
sheet asset that represents the contractual right to receive some or
all of the remaining interest cash flow generated from assets that have
been transferred into a trust (or other special purpose entity), after
taking into account trustee and other administrative expenses, interest
payments to investors, servicing fees, and reimbursements to investors
for losses attributable to the beneficial interests they hold, as well
as reinvestment income and ancillary revenues \18\ on the transferred
assets. Credit-enhancing I/O strips are generally carried on the
balance sheet at the present value of the expected net cash flow that
the banking organization reasonably expects to receive in future
periods on the assets it has securitized, adjusted for some level of
prepayments if relevant to that asset class, and discounted at an
appropriate market interest rate. Typically, when assets are
transferred in a securitization transaction that is accounted for as a
sale under GAAP, the accounting recognition given to the credit-
enhancing I/O strip on the seller's balance sheet results in the
recording of a gain on the portion of the transferred assets that has
been sold. This gain is recognized as income, thus increasing the
banking organization's capital position. In determining whether a
particular interest cash flow functions as a credit-enhancing I/O
strip, the agencies will look to the economic substance of the
transaction, and will reserve the right to identify other cash flows or
spread-related assets as credit-enhancing I/O strips on a case-by-case
basis. For example, including some principal payments with interest and
fee cash flows will not otherwise negate the regulatory capital
treatment of that asset as a credit-enhancing I/O strip. Credit-
enhancing I/O strips include both purchased and retained interest-only
strips that serve in a credit-enhancing capacity, even though purchased
I/O strips generally do not result in the creation of capital on
purchaser's balance sheet.
---------------------------------------------------------------------------

\18\ According to FASB Statement No. 140, ``Accounting for
Transfers and Servicing of Financial Assets and Extinguishments of
Liabilities,'' ancillary revenues include such revenues as late
charges on the transferred assets.
---------------------------------------------------------------------------

5. Credit Derivatives
The proposed definitions of ``recourse'' and ``direct credit
substitute'' cover credit derivatives to the extent that a banking
organization's credit risk exposure exceeds its pro rata interest in
the underlying obligation. The ratings-based approach therefore applies
to rated instruments such as credit-linked notes issued as part of a
synthetic securitization. With the issuance of this final rule, the
agencies reaffirm the validity of the structural and risk-management
requirements of the December 1999 guidance on synthetic securitizations
issued by the Board and the OCC,\19\ while modifying the risk-based
capital treatment detailed therein with the treatment presented in this
final rule.
---------------------------------------------------------------------------

\19\ See, Banking Bulletin 99-43, December, 1999 (OCC); SR
Letter 99-32, Capital Treatment for Synthetic CLOs, November 17,
1999 (Board).
---------------------------------------------------------------------------

6. Credit-Enhancing Representations and Warranties
When a banking organization transfers assets, including servicing
rights, it customarily makes representations and warranties concerning
those assets. When a banking organization purchases

[[Page 59623]]

loan servicing rights, it may also assume representations and
warranties made by the seller or a prior servicer. These
representations and warranties give certain rights to other parties and
impose obligations upon the seller or servicer of the assets. The 2000
Recourse Proposal addressed those particular representations and
warranties that function as credit enhancements, i.e., those where,
typically, a banking organization agrees to protect purchasers or some
other party from losses due to the default or non-performance of the
obligor or insufficiency in the value of collateral. To the extent a
banking organization's representations and warranties function as
credit enhancements to protect asset purchasers or investors from
credit risk, the final rule treats them as recourse or direct credit
substitutes.
The final rule is consistent with the agencies' longstanding
recourse treatment of representations and warranties that effectively
guaranty performance or credit quality of transferred loans. However,
the agencies also recognize that banking organizations typically make a
number of factual warranties unrelated to ongoing performance or credit
quality. These warranties entail operational risk, as opposed to the
open-ended credit risk inherent in a financial guaranty, and are
excluded from the definitions of recourse and direct credit substitute.
Warranties that create operational risk include: warranties that assets
have been underwritten or collateral appraised in conformity with
identified standards, and warranties that provide for the return of
assets in instances of incomplete documentation, fraud or
misrepresentation.
Warranties can impose varying degrees of operational risk. For
example, a warranty that asset collateral has not suffered damage from
hazard entails risk that is offset to some extent by prudent
underwriting practices requiring the borrower to provide hazard
insurance to the banking organization. A warranty that asset collateral
is free of environmental hazards may present acceptable operational
risk for certain types of properties that have been subject to
environmental assessment, depending on the circumstances. The agencies
address appropriate limits for these operational risks through
supervision of a banking organization's loan underwriting, sale, and
servicing practices. Also, a banking organization that provides
warranties to loan purchasers and investors must include associated
operational risks in its risk management of exposures arising from loan
sale or securitization-related activities. Banking organizations should
be prepared to demonstrate to examiners that operational risks are
effectively managed.
The final rule requires recourse or direct credit substitute
treatment for warranties providing assurances about the actual value of
asset collateral, including that the market value corresponds to its
appraised value or that the appraised value will be realized in the
event of foreclosure and sale. Warranties such as these, which make
representations about the future value of a loan or related collateral
constitute an enhancement of the loan transferred and, thus, are
recourse arrangements or direct credit substitutes. One commenter
suggested that a representation that the seller ``has no knowledge'' of
circumstances that could cause a loan to be other than investment
quality is an operational warranty. The agencies agree that if a seller
represents that it has no knowledge of the existence of such
circumstances at the time that the loans are transferred the
representation would not be recourse.
Commenters sought clarification of the agencies' statement in the
2000 Recourse Proposal that early-default clauses are recourse. Early-
default clauses typically give the purchaser of a loan the right to
return the loan to the seller if the loan becomes 30 or more days
delinquent within a stated period after the transfer--four months after
transfer, for example. Once the stated period has expired, the early-
default clause will no longer trigger recourse treatment, provided that
there is no other provision that constitutes recourse.
Several commenters stated that early-default clauses are not
recourse because they are designed to cover loans that, due to their
non-payment within the first few months of origination, most likely
contained underwriting deficiencies. Early-default clauses can allow
for a reasonable but limited period of time for a purchaser to review
loan file documentation. Therefore, the final rule specifically exempts
from recourse treatment, for a limited period of time, these types of
warranties on certain 1-4 family residential mortgage loans. The
agencies have modified the definition of ``credit-enhancing
representations and warranties'' to exclude warranties, such as early-
default clauses and similar warranties that permit the return of
qualifying 1-4 family residential first mortgage loans for a maximum
period of 120 days from the date of transfer. To be excluded from the
definition, however, these warranties must cover only 1-4 family
residential mortgage loans that are eligible for the 50% risk weight
and that were originated within 1 year of the date of transfer. All
other early-default clauses, including those for periods of greater
than 120 days on qualifying 1-4 family residential first mortgages, are
recourse or direct credit substitutes.
The 2000 Recourse Proposal also sought comment on premium refund
clauses. A premium refund clause is a warranty that obligates a seller
who has sold a loan at a price in excess of par, i.e., at a premium, to
refund the premium, either in whole or in part, if the loan defaults or
is prepaid within a certain period of time. Commenters responded that
premium refund clauses are not recourse because they reflect interest
rate risk, not credit risk.
Although premium refund clauses can be triggered as a result of
prepayments, they can also be triggered by defaults. Accordingly,
premium refund clauses are generally credit-enhancing representations
and warranties under the final rule. However, the agencies have
included an exception for premium refund clauses on U.S. government-
guaranteed loans and qualifying 1-4 family first mortgage loans that
impose a refund obligation on a seller for a period not to exceed 120
days from the date of transfer. These types of loans hold significantly
reduced credit risk.
For those warranties not exempt from recourse or direct credit
substitute treatment under the final rule, industry concerns about
assets that are delinquent at the time of transfer or unsound
originations may be dealt with by warranties directly addressing the
condition of the asset at the time of transfer (i.e., creation of an
above described operational warranty) and compliance with stated
underwriting standards. Alternatively, banking organizations might
create warranties with exposure caps that would permit the banking
organization to take advantage of the low-level recourse rule.
7. Clean-Up Calls
The final rule clarifies the agencies' longstanding interpretations
on the use of clean-up calls in a securitization. A clean-up call is an
option that permits a servicer or its affiliate (which may be the
originator) to take investors out of their positions in a
securitization before all of the transferred loans have been repaid.
The servicer accomplishes this by repurchasing the remaining loans in
the pool once the pool balance has fallen below some specified level.
This option in a securitization raises longstanding agency concerns
that a banking organization may implicitly assume a credit-enhancing
position by

[[Page 59624]]

exercising the option when the credit quality of the securitized loans
is deteriorating. An excessively large clean-up call facilitates a
securitization servicer's ability to take investors out of a pool to
protect them from absorbing credit losses and, thus, may indicate that
the servicer has retained or assumed the credit risk on the underlying
pool of loans.
As a result, clean-up calls are treated generally as recourse and
direct credit substitutes. However, because clean-up calls can also
serve an administrative function in the operation of a securitization,
the agencies have included a limited exemption for these options. Under
the final rule, an agreement that permits a banking organization that
is a servicer or an affiliate of the servicer to elect to purchase
loans in a pool is not recourse or a direct credit substitute if the
agreement permits the banking organization to purchase the remaining
loans in a pool when the balance of those loans is equal to or less
than 10 percent of the original pool balance. However, an agreement
that permits the remaining loans to be repurchased when their balance
is greater than 10 percent of the original pool balance is considered
to be recourse or a direct credit substitute. The exemption from
recourse or direct credit substitute treatment for a clean-up call of
10 percent or less recognizes the real market need to be able to call a
transaction when the costs of keeping it outstanding are burdensome.
However, to minimize the potential for using such a feature as a means
of providing support for a troubled portfolio, a banking organization
that exercises a clean-up call should not repurchase any loans in the
pool that are 30 days or more past due. Alternatively, the banking
organization should repurchase the loans at the lower of their
estimated fair value or their par value plus accrued interest.
Regardless of the size of the clean-up call, the agencies will closely
scrutinize any transaction where the banking organization repurchases
deteriorating assets for an amount greater than a reasonable estimate
of their fair value and will take action accordingly.
8. Loan Servicing Arrangements
The definitions of ``recourse'' and ``direct credit substitute''
cover loan servicing arrangements if the banking organization, as
servicer, is responsible for credit losses associated with the serviced
loans. However, cash advances made by residential mortgage servicers to
ensure an uninterrupted flow of payments to investors or the timely
collection of the mortgage loans are specifically excluded from the
definitions of recourse and direct credit substitute, provided that the
residential mortgage servicer is entitled to reimbursement for any
significant advances and this reimbursement is not subordinate to other
claims. To be excluded from recourse and direct credit substitute
treatment, the banking organization, as servicer, should make an
independent credit assessment of the likelihood of repayment of the
servicer advance prior to advancing funds and should only make such an
advance if prudent lending standards are met. Risk-based capital is
assessed only against the amount of the cash advance, and the advance
is assigned to the risk-weight category appropriate to the party
obligated to reimburse the servicer.\20\
---------------------------------------------------------------------------

\20\ The Board has issued a notice of proposed rulemaking that
considers whether a special purpose entity should be characterized
as a bank affiliate and whether asset securitizations should be
classified as covered transactions pursuant to section 23A of the
Federal Reserve Act, 12 U.S.C. 371c. See ``Transactions between
Banks and Their Affiliates'', 66 FR 24186, May 11, 2001 and 66 FR
33649, June 25, 2001. Any final rule resulting from this Proposal
could affect the regulatory capital treatment of servicer cash
advances.
---------------------------------------------------------------------------

If a residential mortgage servicer is not entitled to full
reimbursement, then the maximum possible amount of any nonreimbursed
advances on any one loan must be contractually limited to an
insignificant amount of the outstanding principal on that loan.
Otherwise, the servicer's obligation to make cash advances will not be
excluded from the definitions of recourse and direct credit substitute.
This treatment reflects the agencies' traditional view that servicer
cash advances meeting these criteria are part of the normal mortgage
servicing function and do not constitute credit enhancement.
Commenters responding to the 2000 Recourse Proposal generally
supported the proposed definition of servicer cash advances. Some
commenters, however, expressed concern over the description of
``insignificant'' nonreimbursed advances as advances on any one loan
that are contractually limited to no more than 1% of the outstanding
principal amount on that loan. They argued that this 1% limit would
unfairly penalize smaller loans and was unnecessary.
The agencies suggested the 1% limit in the 2000 Recourse Proposal
in response to commenters' requests for guidance from commenters on the
1997 Proposal. However, upon reconsideration, the agencies agree that
the 1% limit is unnecessarily restrictive for smaller loans.
Accordingly, the final rule does not contain this benchmark.
Banking organizations that act as servicers, however, should
establish policies on servicer advances and use discretion in
determining what constitutes an ``insignificant'' servicer advance. The
agencies will monitor industry practice and may revisit the issue if
this exemption from recourse treatment is used inappropriately.
Further, the agencies will exercise their supervisory authority to
apply recourse or direct credit substitute treatment to servicer cash
advances that expose a banking organization acting as servicer to
excessive levels of credit risk.
9. Interaction With Market Risk Rule
Some commenters responding to the 2000 Recourse Proposal and the
Residuals Proposal asked for clarification of the treatment of a
transaction covered by both the market risk rule and the recourse rule.
This final rule generally applies to positions held in the banking
book.\21\ For banking organizations that comply with the market risk
rules,\22\ positions in the trading book arising from asset
securitizations, including recourse obligations, residual interests,
and direct credit substitutes, should be treated for risk-based capital
purposes in accordance with those rules. However, these banking
organizations remain subject to the 25 percent concentration limit for
credit-enhancing I/O strips.
---------------------------------------------------------------------------

\21\ This rule applies also to banking organizations that hold
positions in their trading book, but are not otherwise subject to
the market risk rules.
\22\ The OTS did not participate in the market risk rulemaking.
As a result, certain OTS definitions--for example, the OTS's
definition of ``face amount'';--differ from those of the other
agencies.
---------------------------------------------------------------------------

10. Reservation of Authority
Banking organizations are developing novel transactions that do not
fit well into the risk-weight categories and credit conversion factors
in the current standards. Banking organizations also are devising novel
instruments that nominally fit into a particular risk-weight category
or credit conversion factor, but that impose risks on the banking
organization at levels that are not commensurate with the nominal risk-
weight or credit conversion factor for the asset, exposure or
instrument. Accordingly, the agencies have clarified their authority,
on a case-by-case basis, to determine the appropriate risk-weight for
assets and credit equivalent amounts and the appropriate credit
conversion factor for off-balance sheet items in these circumstances.
Exercise of this authority by the agencies may result in a higher
or lower risk weight for an asset or credit

[[Page 59625]]

equivalent amount or a higher or lower credit conversion factor for an
off-balance sheet item. This reservation of authority explicitly
recognizes the agencies' retention of sufficient discretion to ensure
that banking organizations, as they develop novel financial assets,
will be treated appropriately under the regulatory capital standards.
Under this authority, the agencies reserve the right to assign risk
positions in securitizations to appropriate risk categories on a case-
by-case basis if the credit rating of the risk position is determined
to be inappropriate.
11. Alternative Capital Calculation for Small Business Obligations
Certain commenters noted that the capital treatment in the
Residuals Proposal would have a significant negative impact on banking
organizations' small business lending. According to these commenters,
the dollar-for-dollar capital requirement and concentration limits for
residual interests arising from asset securitizations under the
Residuals Proposal would apply to asset securitizations involving the
transfer of small business obligations. These commenters concluded
that, unless the Residuals Proposal is amended to exclude small
business obligations from coverage, the capital treatment in the final
rule would contravene section 208 of the CDRI Act. The final rule
retains the alternative capital calculation for small business
obligations that implements section 208 of the CDRI Act.

C. Ratings-Based Approach: Traded and Non-Traded Positions

As described in section II.A., each loss position in an asset
securitization structure functions as a credit enhancement for the more
senior loss positions in the structure. Currently, the risk-based
capital standards do not vary the capital requirement for different
credit enhancements or loss positions to reflect differences in the
relative credit risk represented by the positions.
To address this issue, the agencies are implementing a multi-level,
ratings-based approach to assess capital requirements on recourse
obligations, residual interests (except credit-enhancing I/O strips),
direct credit substitutes, and senior and subordinated securities in
asset securitizations based on their relative exposure to credit risk.
The approach uses credit ratings from the rating agencies to measure
relative exposure to credit risk and determine the associated risk-
based capital requirement. The use of credit ratings provides a way for
the agencies to use determinations of credit quality relied upon by
investors and other market participants to differentiate the regulatory
capital treatment for loss positions representing different gradations
of risk. This use permits the agencies to give more equitable treatment
to a wide variety of transactions and structures in administering the
risk-based capital system.
The use of credit ratings in the final rule is similar to the 2000
Recourse Proposal. Although many commenters expressed concerns about
specific aspects of the 2000 Recourse Proposal, commenters generally
supported the goal of making the capital requirements for asset
securitizations more rational and efficient, and viewed the 2000
Recourse Proposal as a positive step toward this goal. The agencies
have made several changes to the 2000 Recourse Proposal and Residual
Proposal in response to commenters' concerns and based on further
consideration of the issues.
Several commenters on the 2000 Recourse Proposal expressed concern
over reliance on external rating agency ratings for the purposes of
assessing risk-based capital charges for banking organizations. They
asserted that credit ratings are not intended to measure risks
associated with regulatory capital and that, without market discipline
imposed on them, the ratings may not be reliable for that purpose. They
also noted an inherent conflict of interest between a rating agency's
ability to objectively assign a rating upon which regulators can rely
in imposing capital charges and one that measures the risks in a
securitization for the banking organization who is paying for the
rating.
Investors rely on ratings to make investment decisions. This
reliance exerts market discipline on the rating agencies and gives
their ratings market credibility. The market's reliance on ratings, in
turn, gives the agencies confidence that it is appropriate to consider
ratings as a major factor in the risk weighting of assets for
regulatory capital purposes. Further, the use of a single rating will
only be adequate under the ratings-based approach for a position that
is traded. The agencies, however, reserve the authority to override the
use of certain ratings or the ratings on certain instruments, either on
a case-by-case basis or through broader supervisory policy, if
necessary or appropriate to address the risk that an instrument poses
to banking organizations.
Under the ratings-based approach, the capital requirement for a
position is computed by multiplying the face amount of the position by
the appropriate risk weight determined in accordance with the following
tables.\23\ The first chart shown below maps long-term ratings to the
appropriate risk-weights under the final rule. In response to requests
from commenters, the agencies have also included another chart (the
second chart shown below) that maps short-term ratings for asset-backed
commercial paper to the appropriate risk-weights under this rule.
---------------------------------------------------------------------------

\23\ The rating designations (e.g., ``AAA,'' ``BBB,'' ``A-1,''
and ``P-1'') used in the charts are illustrative only and do not
indicate any preference for, or endorsement of, any particular
rating agency designation system.

------------------------------------------------------------------------
Risk weight
Long-term rating category Examples (In percent)
------------------------------------------------------------------------
Highest or second highest AAA or AA........... 20
investment grade.
Third highest investment grade.... A................... 50
Lowest investment grade........... BBB................. 100
One category below investment BB.................. 200
grade.
More than one category below B or unrated........ (\1\)
investment grade, or unrated.

------------------------------------------------------------------------
Risk weight
Short-term rating category Examples (In percent)
------------------------------------------------------------------------
Highest investment grade.......... A-1, P-1............ 20
Second highest investment grade... A-2, P-2............ 50
Lowest investment grade........... A-3, P-3............ 100

[[Page 59626]]

Below investment grade............ Not Prime........... (\1\)
------------------------------------------------------------------------
\1\ Not eligible for ratings-based approach.

The chart for short-term ratings is not identical to the long-term
ratings table because the rating agencies do not assign short-term
ratings using the same methodology as long-term ratings. Each short-
term rating category covers a range of longer-term rating
categories.\24\ For example, a P-1 rating could map to a long-term
rating as high as Aaa or as low as A3.
---------------------------------------------------------------------------

\24\ See, for example, Moody's Global Ratings Guide, June 2001,
p.3.
---------------------------------------------------------------------------

Under the final rule, the ratings-based approach is available for
asset-backed securities,\25\ recourse obligations, direct credit
substitutes and residual interests (other than credit-enhancing I/O
strips). The agencies have excluded credit-enhancing I/O strips from
the ratings-based approach based on their high risk profile, discussed
above at section III.B.4.
---------------------------------------------------------------------------

\25\ Similar to the banking agencies' current approach under
which ``stripped'' mortgage-backed securities are not eligible for
risk weighting at 50% on a ``pass-through'' basis, stripped
mortgage-backed securities are ineligible for the 20% or 50% risk
categories under the ratings-based approach. Currently, OTS also
includes most interest-only and principal-only strips in the 100%
risk-weight category. See 12 CFR 567.6(a)(1)(iv) (introductory
statement) and (a)(1)(iv)(M). However, certain high-quality stripped
mortgage-related securities are eligible for a 20% risk weight under
the OTS' capital standards. OTS recently proposed to conform its
capital treatment for high-quality stripped mortgage-related
securities to that of other agencies, and received not comments in
opposition to this change. See 66 FR 15049, March 15, 2001.
Accordingly, OTS in conforming these aspects of its rule to those of
the other agencies.
---------------------------------------------------------------------------

While the ratings-based approach is available for both traded and
untraded positions, the rule applies different requirement to these
positions. A traded position, for example, is only required to be rated
by one rating agency. A position is defined as ``traded'' if, at the
time it is rated by an external rating agency, there is a reasonable
expectation that in the near future: (1) The position may be sold to
unaffiliated investors relying on the rating; or (2) an unaffiliated
third party may enter into a transaction (e.g., a loan or repurchase
agreement) involving the position in which the third party relies on
the rating of the position.
A few commenters expressed concern over the provision in the 2000
Recourse Proposal that allowed a banking organization to use the single
highest rating obtained on a traded position, stating that doing so
encourages rating-shopping. The agencies agree and, therefore, the
final rule requires a banking organization to use the lowest single
rating assigned to a traded position. Moreover, if a rating changes,
the banking organization must use the new rating.
Rated, but untraded, asset-backed securities, recourse obligations,
direct credit substitutes and residual interests may also be eligible
for the ratings-based approach if they meet certain conditions. To
qualify, the position must be rated by more than one rating agency, the
ratings must be one category below investment grade or better for long-
term positions (or investment grade or better for short-term positions)
by all rating agencies providing a rating, the ratings must be publicly
available, and the ratings must be based on the same criteria used to
rate securities that are traded. If the ratings are different, the
lowest single rating will determine the risk-weight category.
Recourse obligations and direct credit substitutes (other than
residual interests) that do not qualify for the ratings-based approach
(or the internal ratings, program ratings or computer program ratings
approaches outlined below) receive ``gross-up'' treatment, that is, the
banking organization holding the position must hold capital against the
amount of the position plus all more senior positions, subject to the
low-level exposure rule.\26\ This grossed-up amount is placed into a
risk-weight category according to the obligor or, if relevant, the
guarantor or the nature of the collateral. The grossed-up amount
multiplied by both the risk-weight and 8 percent is never greater than
the full capital charge that would otherwise be imposed on the assets
if they were on the banking organization's balance sheet.\27\
---------------------------------------------------------------------------

\26\ ``Gross-up'' treatment means that a position is combined
with all more senior positions in the transaction. The result is
then risk-weighted based on the obligor or, if relevant, the
guarantor or the nature of the collateral. For example, if a banking
organization retains a first-loss position (other than a residual
interest) in a pool of mortgage loans that qualify for a 50% risk
weight, the banking organization would include the full amount of
the assets in the pool, risk-weighted at 50%, in its risk-weighted
assets for purposes of determining its risk-based capital ratio. The
low-level exposure rule provides that the dollar amount of risk-
based capital required for assets transferred with recourse should
not exceed the maximum dollar amount for which a banking
organization is contractually liable. See 12 CFR part 3, appendix A,
Section 3(d) (OCC); 12 CFR 208 and 225, appendix A, III.D.1(g)
(FRB); 12 CFR part 325, appendix A, II.D.1 (FDIC); 12 CFR
567.6(a)(2)(i)(C) (OTS).
\27\ For assets that are assigned to the 100 percent risk-weight
category, the minimum capital charge is 8 percent of the amount of
assets transferred, and banking organizations are required to hold 8
cents of capital for every dollar of assets transferred with
recourse. For assets that are assigned to the 50 percent risk-weight
category, the minimum capital charge is 4 cents of capital for every
dollar of assets transferred with recourse.
---------------------------------------------------------------------------

Residual interests that are not eligible for the ratings-based
approach receive dollar-for-dollar treatment. Dollar-for-dollar
treatment means, effectively, that one dollar in total risk-based
capital must be held against every dollar of a residual interest,
except for credit-enhancing I/Os that have already been deducted from
Tier 1 capital under the concentration limit.\28\ Thus, the capital
requirement for residual interests is not limited by the 8 percent cap
in place under the current risk-based capital system.
---------------------------------------------------------------------------

\28\ Residual interests that are retained or purchased credit-
enhancing I/O strips are first subject to a capital concentration
limit of 25 percent of Tier 1 capital. For risk-based capital
purposes (but not for leverage capital purposes), once this
concentration limit is applied, a banking organization must then
hold dollar-for-dollar capital against the face amount of credit-
enhancing I/O strips remaining.
---------------------------------------------------------------------------

Finally, an unrated position that is senior or preferred in all
respects (including collateralization and maturity) to a rated position
that is traded is treated as if it had the rating assigned to the rated
position. The banking organization, however, must satisfy its
supervisory agency that such treatment is appropriate. Senior unrated
positions qualify for the risk weighting of the subordinated rated
positions in the same securitization transaction as long as the
subordinated rated position (1) is traded and (2) remains outstanding
for the entire life of the unrated position, thus providing full credit
support for the term of the unrated position.

D. Unrated Positions

In response to the 2000 Recourse Proposal and earlier proposals,
commenters expressed concern over the expense and inefficiency of
requiring the purchase of ratings to qualify for the ratings-based
approach and advocated alternative approaches. In response to these
concerns, the final rule incorporates three alternative approaches for
determining the capital

[[Page 59627]]

requirements for certain unrated direct credit substitutes and recourse
obligations. Under each of these approaches, the banking organization
must satisfy its supervisory agency that the use of the approach is
appropriate for the particular banking organization and for the
exposure being evaluated. The final rule limits, however, the risk
weight that may be applied to an exposure under these alternative
approaches to a minimum of 100%.
Under the 2000 Recourse Proposal, only direct credit substitutes
could qualify for beneficial risk-weighting using the three
alternatives to external ratings (i.e., internal ratings, program
ratings, and computer programs). Commenters questioned the agencies'
limitation of the application of these alternative approaches to direct
credit substitutes. After considering the arguments for extending the
application of these approaches to recourse obligations, the agencies
have decided not to permit the internal ratings-based approach to apply
to any positions other than direct credit substitutes issued in
connection with an asset-backed commercial paper program. Industry