[Federal Register: November 5, 1997 (Volume 62, Number 214)]
[Proposed Rules]
[Page 59943-59976]
From the Federal Register Online via GPO Access [wais.access.gpo.gov]
[DOCID:fr05no97-22]
Risk-Based Capital Standards; Recourse and Direct Credit Substitutes;
Proposed Rule
[[Page 59944]]
DEPARTMENT OF THE TREASURY
Office of the Comptroller of the Currency
12 CFR Part 3
[Docket No. 97-22]
RIN 1557-AB14
FEDERAL RESERVE SYSTEM
12 CFR Parts 208 and 225
[Regulations H and Y; Docket No. R-0985]
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. 97-86]
RIN 1550-AB11
Risk-Based Capital Standards; Recourse and Direct Credit
Substitutes
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.
SUMMARY: The Office of the Comptroller of the Currency (OCC), Board of
Governors of the Federal Reserve System (Board), Federal Deposit
Insurance Corporation (FDIC), and Office of Thrift Supervision (OTS),
(collectively, the agencies) are proposing revisions to their risk-
based capital standards to address the regulatory capital treatment of
recourse obligations and direct credit substitutes that expose banks,
bank holding companies, and thrifts (collectively, banking
organizations) to credit risk. The proposal would treat direct credit
substitutes and recourse obligations consistently and would use credit
ratings and possibly certain other alternative approaches to match the
risk-based capital assessment more closely to a banking organization's
relative risk of loss in asset securitizations.
The agencies intend that any final rules adopted in connection with
this proposal that result in increased risk-based capital requirements
for banking organizations apply only to transactions consummated after
the effective date of the final rules.
DATES: Comments must be received on or before February 3, 1998.
ADDRESSES: Comments should be directed to:
OCC: Written comments may be submitted electronically to
regs.comments@occ.treas.gov or by mail to Docket No. 97-22,
Communications Division, Third Floor, Office of the Comptroller of the
Currency, 250 E Street, SW., Washington, DC 20219. Comments will be
available for inspection and photocopying at that address.
Board: Comments, which should refer to Docket No. R-0985, may be
mailed to the Board of Governors of the Federal Reserve System, 20th
Street and Constitution Avenue, NW., Washington, DC 20551, to the
attention of Mr. William Wiles, Secretary. Comments addressed to the
attention of Mr. Wiles may be delivered to the Board's mail room
between 8:45 a.m. and 5:15 p.m., and to the security control room
outside of those hours. Both the mail room and the security control
room are accessible from the courtyard entrance on 20th Street between
Constitution Avenue and C Street, NW. Comments may be inspected in Room
MP500 between 9 a.m. and 5 p.m. weekdays, except as provided in
Sec. 261.8 of the FRB's Rules Regarding Availability of Information, 12
CFR 261.8.
FDIC: Written comments should be addressed to Robert E. Feldman,
Executive Secretary, Attention: Comments/OES, Federal Deposit Insurance
Corporation, 550 17th Street, N.W., Washington, D.C. 20429. Comments
may be hand delivered to the guard station at the rear of the 550 17th
Street Building (located on F Street), on business days between 7:00
a.m. and 5:00 p.m. (Fax number: (202) 898-3838; Internet address:
comments@fdic.gov). Comments may be inspected and photocopied in the
FDIC Public Information Center, Room 100, 801 17th Street, N.W.,
Washington, D.C., between 9:00 a.m. and 4:30 p.m. on business days.
OTS: Send comments to Manager, Dissemination Branch, Records
Management and Information Policy, Office of Thrift Supervision, 1700 G
Street, N.W., Washington, D.C. 20552, Attention Docket No. 97-86. These
submissions may be hand-delivered to 1700 G Street, N.W., from 9:00
a.m. to 5:00 p.m. on business days or may be sent by facsimile
transmission to FAX number (202) 906-7755; or by e-mail:
public.info@ots.treas.gov. Those commenting by e-mail should include
their name and telephone number. Comments will be available for
inspection at 1700 G Street, N.W., from 9:00 to 4:00 p.m. on business
days.
FOR FURTHER INFORMATION CONTACT: OCC: David Thede, Senior Attorney,
Securities and Corporate Practices Division (202/874-5210); Dennis
Glennon, Financial Economist, Risk Analysis Division (202/874-5700); or
Steve Jackson, National Bank Examiner, Treasury and Market Risk (202/
874-5070).
Board: Thomas R. Boemio, Senior Supervisory Financial Analyst (202/
452-2982); or Norah Barger, Assistant Director (202/452-2402), Division
of Banking Supervision and Regulation. For the hearing impaired only,
Telecommunication Device for the Deaf (TDD), Diane Jenkins (202/452-
3544), Board of Governors of the Federal Reserve System, 20th and C
Streets, NW, Washington, DC 20551.
FDIC: Robert F. Storch, Chief, Accounting Section, Division of
Supervision, (202/898-8906), or Jamey G. Basham, Counsel, Legal
Division (202/898-7265).
OTS: John F. Connolly, Senior Program Manager for Capital Policy
(202/906-6465), Supervision Policy; Michael D. Solomon, Senior Policy
Advisor (202/906-5654), Supervision Policy; Fred Phillips-Patrick,
Senior Financial Economist (202/906-7295), Research and Analysis;
Robert Kazdin, Senior Project Manager (202/906-5759), Research and
Analysis; Karen Osterloh, Assistant Chief Counsel (202/906-6639),
Regulation and Legislation Division, Office of Thrift Supervision, 1700
G Street, N.W., Washington, D.C. 20552.
SUPPLEMENTARY INFORMATION:
Table of Contents
I. Introduction and Background
A. Overview
B. Purpose and Effect
C. Background
1. Recourse and Direct Credit Substitutes
2. Prior History
D. Current Risk-based Capital Treatment of Recourse and Direct
Credit Substitutes
1. Recourse
2. Direct Credit Substitutes
3. Problems with Existing Risk-based Capital Treatments of
Recourse Arrangements and Direct Credit Substitutes
E. GAAP Accounting Treatment of Recourse Arrangements
II. Notice of Proposed Rulemaking
A. Definitions
1. Recourse
2. Direct Credit Substitute
3. Risks Other than Credit Risks
4. Implicit Recourse
5. Subordinated Interests in Loans or Pools of Loans
[[Page 59945]]
6. Second Mortgages
7. Representations and Warranties
8. Loan Servicing Arrangements
9. Spread Accounts and Overcollateralization
B. Treatment of Direct Credit Substitutes
C. Multi-level Ratings-based Approach
1. 1994 Notice
2. Effect of Ratings Downgrades
3. Non-traded Positions
D. Face Value and Modified Gross-up Alternatives for Investment
Grade Positions Below the Highest Investment Grade Rating
1. Description of Approaches
2. Examples of Face Value and Modified Gross-up Approaches
E. Alternative Approaches
1. Ratings Benchmark Approach
2. Internal Information Approaches
a. Historical Loss Approach
b. Bank Model Approach
III. Regulatory Flexibility Act
IV. Paperwork Reduction Act
V. Executive Order 12866
VI. OCC and OTS--Unfunded Mandates Reform Act of 1995
I. Introduction and Background
A. Overview
The agencies are proposing to amend their risk-based capital
standards to clarify and change the treatment of certain recourse
obligations, direct credit substitutes, and securitized transactions
that expose banking organizations to credit risk.
This proposal would amend the agencies' risk-based capital
standards to:
<bullet> Define ``recourse'' and revise the definition of ``direct
credit substitute''; 1
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\1\ The OTS is adding a definition of ``standby-type letter of
credit'' to be consistent with the other agencies.
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<bullet> Treat recourse obligations and direct credit substitutes
consistently for risk-based capital purposes; and
<bullet> Vary the capital requirements for traded and non-traded
2 positions in securitized transactions according to their
relative risk exposure, using credit ratings from nationally-recognized
statistical rating organizations 3 (rating agencies) to
measure the level of risk.
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\2\ See section II.C.3 of this preamble for a discussion of the
distinction between ``traded'' and ``non-traded'' positions.
\3\ ``Nationally recognized statistical rating organization''
means an entity recognized by the Division of Market Regulation of
the Securities and Exchange Commission as a nationally recognized
statistical rating organization for various purposes, including the
capital rules for broker-dealers. See SEC Rule 15c3-1(c)(2)(vi)(E),
(F) and (H) (17 CFR 240.15c3-1(c)(2)(vi)(E), (F), and (H).
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Additionally, this proposal discusses and requests comment on two
possible alternatives to the use of credit ratings for non-traded
positions in securitized transactions, either or both of which may be
adopted, in whole or in part, in the final rule. These alternatives
would:
<bullet> Use criteria developed by the agencies, based on the
criteria of the rating agencies, to determine the capital requirements;
or
<bullet> Permit institutions to use historical loss information to
determine the capital requirement for direct credit substitutes and
recourse obligations.
The agencies request comment on all aspects of this proposal.
B. Purpose and Effect
Implementation of all aspects of this proposal would result in more
consistent treatment of recourse obligations and similar transactions
among the agencies, more consistent risk-based capital treatment for
transactions involving similar risk, and capital requirements that more
closely reflect a banking organization's relative exposure to credit
risk.
The agencies intend that any final rules adopted in connection with
this proposal that result in increased risk-based capital requirements
for banking organizations apply only to transactions that are
consummated after the effective date of those final rules. The agencies
intend that any final rules adopted in connection with this proposal
that result in reduced risk-based capital requirements for banking
organizations apply to all transactions outstanding as of the effective
date of those final rules and to all subsequent transactions. Because
some ongoing securitization conduits may need additional time to adapt
to any new capital treatments, the agencies intend to permit asset
securitizations with no fixed term, e.g., asset-backed commercial paper
conduits, to apply the existing capital rules for up to two years after
the effective date of any final rule.
C. Background
1. Recourse and Direct Credit Substitutes
Asset securitization is the process by which loans and other
receivables are pooled, reconstituted into one or more classes or
positions, and then sold. Securitization provides an efficient
mechanism for institutions to buy and sell loan assets and thereby to
make them more liquid.
Securitizations typically carve up the risk of credit losses from
the underlying assets and distribute it to different parties. The
``first dollar'' loss or subordinate position is first to absorb credit
losses; the ``senior'' investor position is last; 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 loss positions in the structure.
For residential mortgages sold through certain Federally-sponsored
mortgage programs, a Federal government agency or Federally-sponsored
agency guarantees the securities sold to investors. However, many of
today's asset securitization programs involve nonmortgage assets or are
not supported in any way by the Federal government or a Federally-
sponsored agency. Sellers of these privately securitized assets
therefore often provide other forms of credit enhancement--first and
second dollar loss positions--to reduce investors' risk of credit loss.
Sellers may provide this credit enhancement themselves through
recourse arrangements. For purposes of this proposal, ``recourse''
refers to any risk of credit loss that an institution retains in
connection with the transfer of its assets. While banking organizations
have long provided recourse in connection with sales of whole loans or
loan participations, recourse arrangements today are frequently
associated with asset securitization programs.
Sellers may also arrange for a third party to provide credit
enhancement 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. For purposes of this proposal,
all forms of third-party enhancements, i.e., all arrangements in which
an institution assumes risk of credit loss from third-party assets or
other claims that it has not transferred, are referred to as ``direct
credit substitutes.'' 4 The economic substance of an
institution's risk of credit loss from providing a direct credit
substitute can be identical to its risk of credit loss from
transferring an asset with recourse.
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\4\ As used in this proposal, the terms ``credit enhancement''
and ``enhancement'' refer to both recourse arrangements and direct
credit substitutes.
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Depending on the type of securitization transaction, a portion of
the total credit enhancement may also be provided internally, as part
of the securitization structure, through the use of spread accounts,
overcollaterali-
zation, or other forms of self-enhancement. Many asset securitizations
use a combination of internal enhancement, recourse, and third-party
enhancement to protect investors from risk of credit loss.
2. Prior History
On June 29, 1990, the Federal Financial Institutions Examination
Council (FFIEC) published a request for comment on recourse
arrangements. See
[[Page 59946]]
55 FR 26766 (June 29, 1990). The publication announced the agencies'
intent to review the regulatory capital, reporting, and lending limit
treatment of assets transferred with recourse and similar transactions,
and set out a broad range of issues for public comment. The FFIEC
received approximately 150 comment letters. The FFIEC then narrowed the
scope of the review to the reporting and capital treatment of recourse
arrangements and direct credit substitutes that expose banking
organizations to credit-related risks. The OTS implemented some of the
FFIEC's proposals (including the definition of recourse) on July 29,
1992 (57 FR 33432).
In July 1992, after receiving preliminary recommendations from an
interagency staff working group, the FFIEC directed the working group
to carry out a study of the likely impact of those recommendations on
banking organizations, financial markets, and other affected parties.
As part of that study, the working group held a series of meetings with
representatives from 13 organizations active in the securitization and
credit enhancement markets. Summaries of the information provided to
the working group and a copy of the working group's letter sent to
participants prior to the meetings are in the FFIEC's public file on
recourse arrangements and are available for public inspection and
photocopying. Additional material provided to the agencies from
financial institutions and others since these meetings has also been
placed in the FFIEC's public file. The FFIEC's offices are located at
2100 Pennsylvania Avenue, NW., Suite 200, Washington, DC 20037.
On May 25, 1994, the agencies published a Federal Register notice
(1994 Notice) containing a proposal to reduce the capital requirement
for banks for low-level recourse transactions (transactions in which
the capital requirement would otherwise exceed an institution's maximum
contractual exposure); to treat first-loss (but not second-loss) direct
credit substitutes like recourse; and to implement definitions of
``recourse,'' ``direct credit substitute,'' and related terms. 59 FR
27116 (May 25, 1994). The 1994 Notice also contained, in an advance
notice of proposed rulemaking, a proposal to use credit ratings to
determine the capital treatment of certain recourse obligations and
direct credit substitutes. The OCC, Board, and FDIC (the Banking
Agencies) have since implemented the capital reduction for low-level
recourse transactions required by section 350 of the Riegle Community
Development and Regulatory Improvement Act, Public Law 103-325, 12
U.S.C. 4808. 60 FR 17986 (OCC, April 10, 1995), 60 FR 8177 (Board,
February 13, 1995); 60 FR 15858 (FDIC, March 28, 1995). (The OTS risk-
based capital regulation already included the low-level recourse
treatment required by 12 U.S.C. 4808. See 60 FR 45618, August 31,
1995.) The other portions of the 1994 Notice will be addressed in this
proposal.
The agencies have also implemented section 208 of the Riegle
Community Development and Regulatory Improvement Act of 1994, Public
Law 103-325, 108 Stat. 2160, 12 U.S.C. 1835, which made available an
alternative risk-based capital treatment for qualifying transfers of
small business obligations with recourse. 60 FR 45611(Board final rule,
August 31, 1995); 60 FR 45605 (FDIC interim rule, August 31, 1995); 60
FR 45617 (OTS interim rule, August 31, 1995); 60 FR 47455 (OCC interim
rule, September 13, 1995).
D. Current Risk-based Capital Treatment of Recourse and Direct Credit
Substitutes
Currently, the agencies' risk-based capital standards apply
different treatments to recourse arrangements and direct credit
substitutes. As a result, capital requirements applicable to credit
enhancements do not consistently reflect credit risk. The Banking
Agencies' current rules are also not entirely consistent with those of
the OTS.
1. Recourse
The agencies' risk-based capital guidelines prescribe a single
treatment for assets transferred with recourse regardless of whether
the transaction is reported as a financing or a sale of assets in a
bank's Consolidated Reports of Condition and Income (Call Report).
Assets transferred with any amount of recourse in a transaction
reported as a financing remain on the balance sheet. Assets transferred
with recourse in a transaction that is reported as a sale create off-
balance sheet exposures. The entire outstanding amount of the assets
sold (not just the amount of the recourse) is converted into an on-
balance sheet credit equivalent amount using a 100% credit conversion
factor, and this credit equivalent amount is risk-weighted.
5 In either case, risk-based capital is held against the
full, risk-weighted amount of the transferred assets, subject to the
low-level recourse rule which limits the maximum risk-based capital
requirement to the bank's maximum contractual obligation.
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\5\ Current rules also provide for special treatment of sales of
small business loan obligations with recourse. See 12 U.S.C. 1835.
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For leverage capital ratio purposes, if a sale with recourse is
reported as a financing, then the assets sold with recourse remain on
the selling bank's balance sheet. If a sale with recourse is reported
as a sale, the assets sold do not remain on the selling bank's balance
sheet.
2. Direct Credit Substitutes
a. Banking Agencies. Direct credit substitutes are treated
differently from recourse under the current risk-based capital
standards. Under the Banking Agencies' standards, 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 dollar amount of the direct credit substitute is
converted into an on-balance sheet credit equivalent so that capital is
held only against the face amount of the direct credit substitute. The
capital requirement for a recourse arrangement, in contrast, is
generally 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. For example, if a direct credit
substitute covers losses up to the first 20% of the assets enhanced,
then the on-balance sheet credit equivalent amount equals that 20%
amount and risk-based capital is held against only the 20% amount. In
contrast, required capital for a first-loss 20% recourse arrangement is
higher because capital is held against the full outstanding amount of
the assets enhanced.
Banking organizations are taking advantage of this anomaly, for
example, by providing first loss letters of credit to asset-backed
commercial paper conduits that lend directly to corporate customers.
This results in a significantly lower capital requirement than if the
loans were on the banking organizations' balance sheets.
Under the proposal, the definition of direct credit substitute is
expanded to include some items that already are partially reflected on
the balance sheet, such as purchased subordinated interests. Currently,
under the Banking Agencies' guidelines, these interests receive the
same capital treatment as off-balance sheet direct credit substitutes.
Purchased subordinated interests are placed in the appropriate risk-
weight category. In contrast, if a banking organization retains a
[[Page 59947]]
subordinated interest in connection with the transfer of its own
assets, this is considered recourse. As a result, the institution must
hold capital against the carrying amount of the retained subordinated
interest as well as the outstanding amount of all senior interests that
it supports.
b. OTS. 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
under its general recourse provisions (except for certain high quality
subordinated mortgage-related securities). 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. Problems With Existing Risk-based Capital Treatments of Recourse
Arrangements and Direct Credit Substitutes.
The agencies are proposing changes to the risk-based capital
standards to address the following major concerns with the current
treatments of recourse and direct credit substitutes:
<bullet> Different amounts of capital can be required for recourse
arrangements and direct credit substitutes that expose a banking
organization to equivalent risk of credit loss.
<bullet> The capital treatment does not recognize differences in
risk associated with different loss positions in asset securitizations.
<bullet> The current standards do not provide uniform definitions
of recourse, direct credit substitute, and associated terms.
E. GAAP Accounting Treatment of Recourse Arrangements
The Banking Agencies' regulatory capital treatment of asset
transfers with recourse differs from the accounting treatment of asset
transfers with recourse under generally accepted accounting principles
(GAAP). Under GAAP, an institution that transferred an asset with
recourse before January 1, 1997, must reserve in a recourse liability
account the probable expected losses under the recourse obligation and
meet certain other criteria in order to treat the asset as sold. An
institution that transfers an asset with recourse after December 31,
1996, must surrender control over the asset and receive consideration
other than a beneficial interest in the transferred asset in order to
treat the asset as sold. The institution must recognize a liability for
its recourse obligation, measuring this liability at its fair value or
by alternative means. Although the Banking Agencies have adopted GAAP
for reporting sales of assets with recourse in 1997,6 the
agencies continue to require risk-based capital in addition to the GAAP
recourse liability account for recourse obligations.
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\6\ The OTS has followed GAAP since 1989 for reporting purposes
and for computation of the capital leverage ratio.
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The agencies have considered the arguments that several commenters
(responding to the 1994 Notice) made for adopting for regulatory
capital purposes the GAAP treatment for all assets sold with recourse,
including those sold with low levels of recourse. Under such a
treatment, assets sold with recourse in accordance with GAAP would have
no capital requirement, but the GAAP recourse liability account would
provide some level of protection against losses.
One of the principal purposes of regulatory capital is to provide a
cushion against unexpected losses. In contrast, the GAAP recourse
liability account is, in effect, a specific reserve that primarily
takes into account the probable expected losses under the recourse
provision. The capital guidelines explicitly state that specific
reserves may not be included in regulatory capital.
Even though a transferring institution may reduce its exposure to
potential catastrophic losses by limiting the amount of recourse it
provides, it may still retain, in many cases, the bulk of the credit
risk inherent in the assets. For example, an institution transferring
high quality assets with a reasonably estimated expected loss rate of
one percent that retains ten percent recourse in the normal course of
business will sustain the same amount of losses it would have had the
assets not been transferred. This occurs because the amount of exposure
under the recourse provision is very high relative to the amount of
expected losses. In such transactions the transferor has not
significantly reduced its risk for purposes of assessing regulatory
capital and should continue to be assessed regulatory capital as though
the assets had not been transferred.
Further, the agencies are concerned that an institution
transferring assets with recourse might significantly underestimate its
losses under the recourse provision or the fair value of its recourse
obligation, in which case it would not establish an appropriate GAAP
recourse liability account for the exposure. If the transferor recorded
an inappropriately small liability in the GAAP recourse liability
account for a succession of asset transfers, it could accumulate large
amounts of credit risk that would be only partially reflected on the
balance sheet.
For these reasons, the agencies have not proposed to adopt for
regulatory capital purposes the GAAP treatment for assets sold with
recourse. The agencies invite additional comments on this issue.
II. Notice of Proposed Rulemaking
This proposal would amend the agencies' risk-based capital
standards as follows:
<bullet> Define recourse and revise the definition of direct credit
substitute (See section II.A of this preamble);
<bullet> Treat recourse obligations and direct credit substitutes
consistently for risk-based capital purposes (See section II.B of this
preamble); and
<bullet> Vary the capital requirements for traded and non-traded
positions in securitized asset transactions according to their relative
risk exposure, using credit ratings from rating agencies to measure the
level of risk (See sections II.C and II.D of this preamble).
Additionally, this notice discusses and requests comment on two
possible alternatives to the use of credit ratings for non-traded
positions in securitized transactions, either or both of which may be
adopted, in whole or in part, in the final rule (See section II.E of
this preamble). These alternatives would:
<bullet> Use criteria developed by the agencies, based on the
criteria of the rating agencies, to determine the capital requirements;
or
<bullet> Permit institutions to use historical loss information to
determine the capital requirements for direct credit substitutes and
recourse obligations.
A. Definitions
1. Recourse
The proposal defines recourse to mean any arrangement in which an
institution retains risk of credit loss in connection with an asset
transfer, if the risk of credit loss exceeds a pro rata share of the
institution's claim on the assets. The proposed definition of recourse
is consistent with the Banking Agencies' longstanding use of this term,
and is intended to incorporate into the risk-based capital standards
existing agency practices regarding retention of risk in asset
transfers.7
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\7\ The OTS currently defines the term ``recourse'' more broadly
than the proposal to include arrangements involving credit risk that
a thrift assumes or accepts from third-party assets as well as risk
that it retains in an asset transfer. Under the proposal, as
explained below, credit risk that an institution assumes from third-
party assets would fall under the definition of ``direct credit
substitute'' rather than ``recourse.''
Currently, the term ``recourse'' is not explicitly defined 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''). Once a
definition of recourse is adopted in the risk-based capital guidelines,
the Banking Agencies would remove the cross-reference to the Call
Report instructions from the guidelines. The OTS capital regulation
currently provides a definition of the term ``recourse,'' which would
also be replaced once a final definition of recourse is adopted.
2. Direct Credit Substitute
The proposed definition of ``direct credit substitute'' is intended
to mirror the definition of recourse. The term ``direct credit
substitute'' would refer to any arrangement in which an institution
assumes risk of credit-related losses from assets or other claims it
has not transferred, if the risk of credit loss exceeds the
institution's pro rata share of the assets or other claims. Currently,
under the Banking Agencies' guidelines, this term covers guarantees and
guarantee-type arrangements. As revised, it would also explicitly
include items such as purchased subordinated interests, agreements to
cover credit losses that arise from purchased loan servicing rights,
and subordinated extensions of credit that provide credit enhancement.
3. Risks Other than Credit Risks
A capital charge would be assessed only against arrangements that
create exposure to credit or credit-related risks. This continues the
agencies' current practice and is consistent with the risk-based
capital standards' traditional focus on credit risk. The agencies have
undertaken other initiatives to ensure that the risk-based capital
standards take interest rate risk and other non-credit related market
risks into account.
4. Implicit Recourse
The definitions cover all arrangements that are recourse or direct
credit substitutes in form or in substance. Recourse may also exist
when an institution assumes risk of loss without an explicit
contractual agreement or, if there is a contractual limit, when the
institution assumes risk of loss in amounts exceeding the limit. The
existence of implicit recourse is often a complex and fact-specific
issue, usually demonstrated by an institution's actions beyond any
contractual obligation. Actions that may constitute implicit recourse
include: (a) Providing voluntary support for a securitization by
selling assets to a trust at a discount from book value; (b) exchanging
performing for non-performing assets; or (c) other actions that result
in a significant transfer of value in response to deterioration in the
credit quality of a securitized asset pool.
To date, the agencies have taken the position that when an
institution provides implicit recourse, it should generally hold
capital in the same manner as for assets sold with recourse. However,
because of the complexity and fact-specific nature of many implicit
recourse arrangements, questions have been raised as to how much risk
the institution has effectively retained as a result of its actions and
whether a different capital treatment would be warranted in some
circumstances. To assist the agencies in assessing various types of
implicit recourse arrangements, comment is requested on the following:
(Question 1) What types of actions should be considered implicit
recourse, and how should the agencies treat these actions for
regulatory capital purposes? Should the agencies establish different
capital requirements for various types of implicit recourse
arrangements? If so, how should appropriate capital requirements be
determined for different types of implicit recourse arrangements?
Please provide relevant data to support any recommended capital
treatment.
The agencies may issue additional interpretive guidance as needed
to further clarify the circumstances in which an institution will be
considered to have provided implicit recourse.
One commenter responding to the 1994 Notice asked for clarification
that a repurchase triggered by a breach of a standard representation or
warranty (as defined below) would not be considered implicit recourse.
Such a repurchase would not constitute implicit recourse because the
repurchase is required by a contractual obligation created at the time
of the sale.
5. Subordinated Interests in Loans or Pools of Loans
The definitions of recourse and direct credit substitute explicitly
cover an institution's ownership of subordinated interests in loans or
pools of loans. This continues the Banking Agencies' longstanding
treatment of retained subordinated interests as recourse and recognizes
that purchased subordinated interests can also function as credit
enhancements. (The OTS currently treats both retained and purchased
subordinated securities as recourse obligations.) Subordinated
interests generally absorb more than their pro rata share of losses
(principal or interest) from the underlying assets in the event of
default. For example, a multi-class asset securitization may have
several classes of subordinated securities, each of which provides
credit enhancement for the more senior classes. Generally, the holder
of any class that absorbs more than its pro rata share of losses from
the total underlying assets is providing credit protection for all more
senior classes.8
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\8\ Current OTS risk-based capital guidelines exclude certain
high-quality subordinated mortgage-related securities from treatment
as recourse arrangements due to their credit quality. Consistent
with these capital guidelines, the proposed OTS rule text includes
the face value of high-quality subordinated mortgage-related
securities in the 20% risk weight category.
---------------------------------------------------------------------------
Two commenters questioned the treatment of purchased subordinated
interests as recourse. Subordinated interests expose holders to
comparable risk regardless of whether the interests are retained or
purchased. If purchased subordinated interests were not treated as
recourse, institutions could avoid recourse treatment by swapping
retained subordinated interests with other institutions or by
purchasing subordinated interests in assets originated by a conduit.
The proposal would mitigate the effect of treating purchased
subordinated interests as recourse by reducing the capital requirement
on interests that qualify under the multi-level approach described in
sections II.C, D, and E of this preamble.
6. Second Mortgages
Second mortgages or home equity loans would generally not be
considered recourse or direct credit substitutes, unless they actually
function as credit enhancements by facilitating the sale of the first
mortgage. For example, this may occur if a lender has a program of
originating first and second mortgages contemporaneously on the same
property and then selling the first mortgage and retaining the second.
In such a program, a second mortgage can function as a substitute for a
recourse arrangement because it is intended that the holder of the
second mortgage will absorb losses before the holder of the first
mortgage does if the borrower fails to make all payments due on both
loans.
The preamble to the 1994 Notice stated that a second mortgage
originated
[[Page 59949]]
contemporaneously with the first mortgage would be presumed to be
recourse. Many commenters criticized this position as overly broad. The
agencies agree and do not propose to retain the presumption.
However, the agencies expect institutions to follow prudent
underwriting practices in making combined extensions of credit (i.e., a
contemporaneous first and second mortgage loan) or other second
mortgages to a single borrower. If an institution does not apply
prudent underwriting standards in making combined loans, the agencies
will consider this practice in determining whether the institution is
using such mortgages to retain recourse and generally in evaluating the
soundness of the institution's underwriting standards and in
determining the adequacy of the institution's capital.
7. 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 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 definitions in this proposal would treat
as recourse or direct credit substitutes any representations or
warranties that create exposure to default risk or any other form of
open-ended, credit-related risk from the assets that is not
controllable by the seller or servicer. This reflects the agencies'
current practice with respect to recourse arising out of
representations and warranties, and explicitly recognizes that a
servicer with purchased loan servicing rights can also take on risk
through servicer representations and warranties.
The agencies recognize, however, that the market requires asset
transferors and servicers to make certain representations and
warranties, and that most of these present only normal operational
risk. Currently, the agencies have no formal definitions distinguishing
between these types of standard representations and warranties and
those that create recourse or direct credit substitutes. The proposal
therefore defines the term ``standard representations and warranties''
and provides that seller or servicer representations or warranties that
meet this definition are not considered to be recourse obligations or
direct credit substitutes.
Under the proposal, ``standard representations and warranties'' are
those that refer to an existing state of facts that the seller or
servicer can either control or verify with reasonable due diligence at
the time the assets are sold or the servicing rights are transferred.
These representations and warranties will not be considered recourse or
direct credit substitutes, provided that the seller or servicer
performs due diligence prior to the transfer of the assets or servicing
rights to ensure that it has a reasonable basis for making the
representation or warranty. The term ``standard representations and
warranties'' also covers contractual provisions that permit the return
of transferred assets in the event of fraud or documentation
deficiencies, (i.e., if the assets are not what the seller represented
them to be), consistent with the current Call Report Instructions
governing the reporting of asset transfers. After a final definition of
``standard representations and warranties'' is adopted for the risk-
based capital standards, the Banking Agencies would recommend to the
FFIEC that the Call Report Instructions be changed to conform to the
capital guidelines and the OTS would similarly amend the instructions
for the Thrift Financial Report (TFR).
Examples of ``standard representations and warranties'' include
seller representations that the transferred assets are current (i.e.,
not past due) at the time of sale; that the assets meet specific,
agreed-upon credit standards at the time of sale; or that the assets
are free and clear of any liens (provided that the seller has exercised
due diligence to verify these facts). An example of a nonstandard
representation and warranty is an agreement by the seller to buy back
any assets that become more than 30 days past due or default within a
designated time period after the sale. Another example of a nonstandard
representation and warranty is a representation that all properties
underlying a pool of transferred mortgages are free of environmental
hazards. This representation is not verifiable by the seller or
servicer with reasonable due diligence because it is not possible to
absolutely verify that a property is, in fact, free of all
environmental hazards. Such an open-ended guarantee against the risk
that unknown but currently existing hazards might be discovered in the
future would be considered recourse or a direct credit substitute.
However, a seller's representation that all properties underlying a
pool of transferred mortgages have undergone environmental studies and
that the studies revealed no known environmental hazards would be a
``standard representation and warranty'' (assuming that the seller
performed the requisite due diligence). This is a verifiable statement
of facts that would not be considered recourse or a direct credit
substitute.
Some commenters responding to the 1994 Notice supported this
proposed definition. Many commenters addressing the definition opposed
it. Commenters objected to the definition for the following reasons:
treating representations and warranties as recourse would place banks
at a competitive disadvantage with other institutions; representations
and warranties are not equivalent to recourse because the risk involved
may be considerably less than the risk of borrower default; and
representations and warranties that relate to operational risk should
not be recourse because recourse is supposed to address only credit
risks. Some commenters suggested the agencies replace the due diligence
requirement with a ``not known to be false'' standard.
The agencies have decided to retain the proposed definition of
standard representations and warranties for purposes of this proposal.
Where a representation or warranty functions as recourse, failure to
recognize the recourse obligation and to require appropriate capital
would create a loophole that would defeat the purposes of the proposal.
The definitions of ``recourse,'' ``direct credit substitute,'' and
``standard representations and warranties'' are intended to treat as
recourse or a direct credit substitute only those representations or
warranties that create exposure to default risk or any other form of
open-ended, credit-related risk from the assets that is not
controllable by the seller or servicer. The agencies wish to clarify
that only those representations and warranties that expose an
institution to credit risk (as opposed to interest rate risk) will be
classified as recourse or direct credit substitutes.
The proposal would treat as recourse a representation or warranty
that functions as recourse but that is guaranteed by a third party. The
agencies request comment on whether the recourse rules should place
assets subject to a representation or warranty that constitutes
recourse in the 20 percent risk weight category if a third party
guarantees the representation or warranty and has unsecured debt that
is rated in the highest rating category.
[[Page 59950]]
8. Loan Servicing Arrangements
The proposed definitions of ``recourse'' and ``direct credit
substitute'' cover loan servicing arrangements if the servicer is
responsible for credit losses associated with the loans being serviced.
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.9 Such advances are assessed risk-based capital
only against the amount of the cash advance, and are assigned to the
risk-weight category appropriate to the party obligated to reimburse
the servicer.
---------------------------------------------------------------------------
\9\ Servicer cash advances include disbursements made to cover
foreclosure costs or other expenses arising from a loan in order to
facilitate its timely collection (but not to protect investors from
incurring these expenses).
---------------------------------------------------------------------------
If the 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 in order
for the obligation to make cash advances to 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 enhancements.
Commenters generally supported the proposed definition of servicer
cash advances. Some commenters asked for clarification of the terms
``insignificant'' and whether ``reimbursement'' includes reimbursement
payable out of subsequent collections or reimbursement in the form of a
general claim on the party obligated to reimburse the servicer.
Nonreimbursed advances contractually limited to no more than one
percent of the amount of the outstanding principal would be considered
insignificant. Reimbursement includes reimbursement payable from
subsequent collections and reimbursement in the form of a general claim
on the party obligated to reimburse the servicer, provided that the
claim is not subordinated to other claims on the cash flows from the
underlying asset pool.
9. Spread Accounts and Overcollateralization
Several commenters requested that the agencies state in their rules
that spread accounts and overcollateralization do not impose a risk of
loss on an institution and are not recourse. By its terms, the
definition of recourse covers only the retention of risk in a sale of
assets. Neither a spread account (unless reflected on an institution's
balance sheet) nor overcollateralization ordinarily impose a risk of
loss on an institution, so neither would fall within the proposed
definition of recourse. However, a spread account reflected as an asset
on an institution's balance sheet would be a form of recourse or direct
credit substitute and would be treated accordingly for risk-based
capital purposes.
B. Treatment of Direct Credit Substitutes
The agencies are proposing to extend the current risk-based capital
treatment of asset transfers with recourse, including the low-level
recourse rule, to direct credit substitutes. As previously explained,
the current risk-based capital assessment for a direct credit
substitute such as a standby letter of credit may be dramatically lower
than the assessment for a recourse provision that creates an identical
exposure to risk. As noted previously, the OTS capital rule already
treats most direct credit substitutes (other than financial standby
letters of credit) in the same manner as recourse obligations.
Currently, an institution that sells assets with 10 percent
recourse must hold capital against the full amount of the assets
transferred. On the other hand, an institution that extends a letter of
credit covering the first 10 percent of losses on the same pool of
assets must hold capital against only the face amount of the letter of
credit. Banking organizations are taking advantage of this anomaly by
providing first loss letters of credit to asset-backed commercial paper
conduits that lend directly to corporate customers, which results in a
significantly lower capital requirement than if the loans had been on
the organizations' balance sheets and were sold with recourse.
In the 1994 Notice, the agencies proposed to change only the
treatment of direct credit substitutes that absorb the first dollars of
losses from the assets enhanced. The agencies proposed to delay
changing the treatment of other direct credit substitutes until a
multi-level approach could be implemented. Some commenters suggested
that the agencies adopt a comprehensive approach, implementing a change
in the treatment of direct credit substitutes only in the context of a
multi-level approach, and observed that a piecemeal approach would be
unduly disruptive. The agencies agree and now propose to implement the
change in the treatment of direct credit substitutes in combination
with the multi-level approach. As proposed, the multi-level approach
applies to direct credit substitutes and recourse obligations related
to asset securitizations. The agencies request comment on how the final
rule could prudently and effectively apply the multi-level approach to
direct credit substitutes and recourse obligations not related to asset
securitizations.
Several commenters objected to the proposed treatment of direct
credit substitutes as recourse. Commenters objected that the proposed
capital treatment would impair the competitive position of U.S. banks
and thrifts and that the business of providing third-party credit
enhancements has historically been safe and profitable for banks.
Notwithstanding these concerns, the agencies believe that the current
treatment of direct credit substitutes is not consistent with the
treatment of recourse obligations, and that the difference in treatment
between the two forms of credit enhancement invites institutions to
convert recourse obligations into direct credit substitutes in order to
avoid the capital requirement applicable to recourse obligations and
balance-sheet assets. The agencies request comment on the proposed
treatment of direct credit substitutes and on the effect of the
proposed treatment on the competitive position of U.S. banks.
The Banking Agencies have raised the issue of increasing the
capital requirement for direct credit substitutes and lowering the
capital requirement for highly-rated senior securities with the bank
supervisory authorities from the other countries represented on a
subgroup of the Basle Committee on Banking Supervision in an effort to
eliminate competitive inequities.
C. Multi-level Ratings-based Approach
Many asset securitizations carve up the risk of credit losses from
the underlying assets and distribute it to different parties. A credit
enhancement (that is, a recourse arrangement or direct credit
substitute) that has no prior loss protection is a ``first dollar''
loss position. There may be one or more layers of additional credit
enhancement after the first dollar loss position. Each loss position
functions as a credit enhancement for the more senior loss
[[Page 59951]]
positions in the structure. Currently, the risk-based capital standards
do not vary the rate of capital assessment with differences in credit
risk represented by different credit enhancement or loss positions.
To address this issue, the agencies are proposing a ``multi-level''
approach to assessing capital requirements on recourse obligations,
direct credit substitutes, and senior securities in asset-
securitizations based on their relative exposure to credit risk. The
agencies are proposing a ratings-based approach that would use credit
ratings from the rating agencies to measure relative exposure to credit
risk and to determine the associated risk-based capital requirement.
The use of credit ratings would provide a way for the agencies to use
market determinations of credit quality to identify different loss
positions for capital purposes in an asset securitization structure.
This may permit the agencies to give more equitable treatment to a wide
variety of transactions and structures in administering the risk-based
capital system.
Under the ratings-based approach, the capital requirement for a
recourse obligation, direct credit substitute, or senior security would
be determined as follows: 10
---------------------------------------------------------------------------
\10\ In this preamble, ``AAA'' refers to the highest investment-
grade rating, and ``AA'', ``A'', and ``BBB'' refer to other
investment-grade ratings. These rating designations are illustrative
and do not indicate any preference or endorsement of any particular
rating agency designation system.
---------------------------------------------------------------------------
<bullet> A position rated in the highest investment grade rating
category would receive a 20 percent risk weight.
<bullet> A position rated investment grade but not in the highest
rating category would receive one of two alternative treatments the
agencies are considering: (1) The ``face value'' option would apply a
100 percent risk weight to the book value or face amount of the
position; or (2) the ``modified gross-up'' option would apply a 50
percent risk weight to the amount of the position plus all more senior
positions. (Section II.D of this preamble discusses and provides
examples of these two alternatives.)
<bullet> Recourse obligations and direct credit substitutes not
qualifying for a reduced capital charge and positions rated below
investment grade would receive ``gross-up'' treatment--the institution
holding the position would hold capital against the amount of the
position plus all more senior positions, subject to the low-level
recourse rule.11
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\11\ Under the ``gross-up'' treatment, a position is combined
with all more senior positions in the transaction. The result is
then risk-weighted based on the nature of the underlying assets. For
example, if an institution retains a first-loss position in a pool
of mortgage loans that qualify for a 50 percent risk weight, the
institution would include the full amount of the assets in the pool,
risk-weighted at 50 percent, in its risk-weighted assets for
purposes of determining its risk-based capital ratio. The ``low
level'' recourse rule limits the capital requirement for recourse
obligations to the institution's maximum contractual obligation. 12
U.S.C. 4808.
---------------------------------------------------------------------------
If a recourse obligation, direct credit substitute, or senior
security receives different ratings from the rating agencies, the
highest ratings would determine the capital treatment. For traded
positions, the single highest rating would apply. For positions that
require two ratings (see section II.C.3 of this preamble), the lower of
the two highest ratings would apply.
1. 1994 Notice
The 1994 Notice described, in an advance notice of proposed
rulemaking, a ratings-based approach under which investment grade
positions rated in the highest rating category would receive a 20
percent risk weight and other investment grade positions would receive
a 100 percent risk weight. Some commenters responding to the 1994
Notice supported the ratings-based approach described in that notice as
a flexible, efficient, market-oriented way to measure risk in
securitizations. Many commenters also noted that a ratings-based
approach was not a perfect or complete solution, especially for non-
traded positions that would otherwise not need to be rated. The
agencies recognize additional options for non-traded positions could be
useful in conjunction with or in lieu of the ratings-based approach and
are considering other approaches, which are described in section II.E
of this preamble.
In the 1994 Notice the agencies suggested that a ratings-based,
multi-level approach should be restricted to transactions involving the
securitization of large, diversified asset pools in which all forms of
first dollar loss credit enhancement are either completely free of
third-party performance risk or are provided internally as part of the
securitization structure. Additionally, the agencies had suggested that
the ratings-based approach be available only for positions other than
first-loss positions. Many commenters pointed out that credit ratings
incorporate this information and that the threshold criteria were
redundant. The agencies agree and have not included these criteria in
the proposal.
2. Effect of Ratings Downgrades
The ratings-based approach would be based on current ratings, so
that a rating downgrade or withdrawal of a rating could change the
treatment of a position under the proposal. However, a downgrade by a
single rating agency rating would not affect the capital treatment of a
position if the position still qualified for the treatment under
another rating from a different rating agency.
3. Non-traded Positions
In response to the 1994 Notice, one rating agency expressed concern
that regulatory use of ratings could undermine the integrity of the
rating process.12 Ordinarily, according to the commenter,
there is a tension between the interests of the investors who rely on
ratings and the interests of the issuers who pay rating agencies to
generate ratings. Under the ratings-based approach, the holder of a
recourse obligation or direct credit substitute that is not traded or
sold may, in some cases, ask for a rating just to qualify for a
favorable risk weight. The rating agency expressed a strong concern
that, without the counterbalancing interest of investors who will be
relying on the rating, rating agencies may have an incentive to issue
inflated ratings.
---------------------------------------------------------------------------
\12\ See T. McGuire, Moody's Investors Service, Ratings in
Regulation: A Petition to the Gorillas (1995).
---------------------------------------------------------------------------
In response to this concern, the agencies have developed proposed
criteria to reduce the possibility of inflated ratings and
inappropriate risk weights if ratings are used for a position that is
not traded. The agencies are proposing that such a position could
qualify for the ratings-based approach if: (1) It qualifies under
ratings from two different rating agencies; (2) the ratings are
publicly available; (3) the ratings are based on the same criteria used
to rate securities sold to the public; and (4) at least one position in
the securitization is traded.
For purposes of this proposal a position is considered ``traded''
if, at the time it is rated, there is a reasonable expectation that in
the near future: (1) The position may be sold to investors relying on
the rating or (2) a third party may enter into a transaction such as a
loan or repurchase agreement involving the position in which the third
party relies on the rating of the position.
In Section II.E of this preamble, the agencies describe two
alternative approaches to the ratings-based approach for non-traded
securitization positions: the ``ratings benchmark'' approach and the
``historical loss'' approach. The agencies may decide to adopt either
or both of these approaches, or portions of them, to either replace or
supplement the ratings-
[[Page 59952]]
based approach for non-traded positions.
(Question 2) How could the agencies prudently and effectively apply
the multi-level approach to direct credit substitutes and recourse
obligations not related to asset securitizations?
(Question 3) What would be the most appropriate oversight mechanism
for verifying ratings on nontraded positions? For instance, should an
institution be required to obtain a detailed explanation from the
rating agency of the basis for the rating on the non-traded position?
Should the institution be required to make this substantiating
information available to the regulatory agencies for review purposes?
(Question 4) How can the agencies determine if a rating on a non-
traded position is inappropriately high? Does any available evidence
show that regulatory rules based on ratings for traded positions have
led to inappropriately high ratings?
(Question 5). For a rated position to be considered traded, an
institution must have a reasonable expectation when the position is
rated that a sale or other transaction involving the position will take
place in the near future. The agencies request comment on this
definition and on the time period that is appropriate to use for
defining the ``near future.''
D. Face Value and Modified Gross-up Alternatives for Investment Grade
Positions Below the Highest Investment Grade Rating
1. Description of Approaches
The agencies are seeking comment on two alternative approaches for
calculating the capital requirement for investment grade positions
rated below the highest investment grade level (i.e.,
AAA).13 One alternative, the ``face value'' approach, would
apply a 100 percent risk weight to the book value or face amount of all
investment grade positions below the highest investment grade level,
regardless of their position within a securitization structure. The
other alternative, the ``modified gross-up'' approach, would gross-up
all investment grade positions below the highest investment grade level
and then apply a 50 percent risk weight to the grossed-up amount. For
senior investment grade positions below the highest investment grade
level, this approach would have the effect of applying a 50 percent
risk weight to these positions.14 The agencies seek comment
on which of these two alternative approaches should be adopted or on
possible alternatives to the two described here.
---------------------------------------------------------------------------
\13\ The option that is chosen would be applicable to the
ratings benchmark and historical loss approaches discussed later in
this preamble.
\14\ If a subordinated position receives the highest investment
grade rating, it would not be grossed up under the modified gross-up
approach. This is due to the relatively low risk implied by the
rating.
---------------------------------------------------------------------------
a. Rationale for the Modified Gross-Up Proposal.--The modified
gross-up approach is being proposed because of a concern that junior
positions that represent only a small portion of a securitization (so-
called ``thin-strip'' mezzanine positions) may qualify for an
investment grade rating despite a concentration of risk on the position
that makes them substantially more risky than investment grade whole
securities with the same underlying collateral. Some rating agencies do
not take into account the severity of loss posed by this risk
concentration when rating these mezzanine positions. Other rating
agencies do so in a way that may be insufficient for risk-based capital
purposes. (See detailed explanations in subsections b and c).
An underlying premise of the modified gross-up approach is that an
investment grade thin-strip mezzanine piece likely poses more risk of a
larger percentage loss than a similarly rated whole asset-backed
security. This additional risk is related to the variability of losses
on the mezzanine position.15
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\15\ The variability of loss can be characterized by its
variance, which measures the distribution of potential losses around
the expected loss. The larger the variance, the more likely that the
actual outcome will be further away from the expected loss. For
example, consider two securities with the same expected loss. The
first security has two possible loss scenarios, $7 and $13, that
each have a probability of 50 percent. The expected loss on this
security is $10, but its variance is 9 and its standard deviation is
3. A second security has two possible loss scenarios, $0 and $20,
that also have probabilities of 50 percent. The expected loss on
this security is also $10, but its variance is 100 and its standard
deviation is 10. The variances and standard deviations for the two
securities are very different. From a capital adequacy standpoint,
the second security poses a greater risk of loss than the first
security. Hence, the second security should have a larger capital
cushion, even though the expected loss on both positions is the
same.
---------------------------------------------------------------------------
Additionally, there is some evidence that investors account for the
additional concentration of credit risk in thin-strip mezzanine
positions by demanding higher yields for these positions. This is
especially the case for ratings that do not account for severity of
loss on the mezzanine position.
The modified gross-up capital treatment is designed to account for
the fact that a thin-strip mezzanine position and whole security with
the same credit ratings have similar credit risks and should,
therefore, have similar dollar capital requirements. Relative to the
``face value'' treatment, it would more fully account for the
concentration risk in these positions as it relates to the current
risk-based capital framework.
The modified gross-up proposal would gross-up mezzanine positions
to take into account any additional credit risk concentration that may
not be fully captured by the ratings. However, if such positions are
rated investment grade, but are below the highest investment grade
level, this proposal would place their grossed-up amounts in the 50
percent risk weight category. In addition, senior investment grade
positions below the highest investment grade level would be placed in
the 50 percent risk weight category. The 50 percent risk weight was
selected because it lies between the agencies' proposed 20 percent risk
weight for the highest investment grade level and the 100 percent risk
weight that applies to most positions below investment grade that would
be fully grossed-up in this proposed rule.
b. Concerns with Ratings Based on Probability of Default. The
agencies understand that certain rating agencies base their ratings on
the probability that the position will experience any losses,
regardless of the severity of loss on the position. These types of
ratings will be referred to as ``probability of default'' ratings.
If a rating for a security is based solely on the probability of
default (i.e., the probability of any losses), both a whole asset-
backed security and a junior security carved out of that whole security
will receive exactly the same rating. Both securities have the same
probability of default. Since the junior piece is smaller than the
whole security, any losses on the security's underlying loan pool will
create a larger loss as a percentage of the junior piece (i.e., a
higher loss severity) than the percentage loss on the larger whole
security.
Consider the following: Assume that $1,050 in commercial loans are
used to create a $1,000 whole security, Security 1, and a $50 credit
enhancement supporting Security 1. The $1,000 security receives the
lowest investment grade rating (BBB), based on the $50 credit
enhancement (the C piece). The $1,000 security is subsequently divided
into two pieces, a $900 senior piece, Security 2A (the A piece), and a
$100 junior piece, Security 2B (the B piece, which is the mezzanine
position between the A and C pieces). The senior piece receives a AAA
rating because its probability of default has decreased. The junior
piece, on its own, will still receive a BBB rating because its
[[Page 59953]]
probability of default is the same as the $1,000 whole security prior
to dividing the whole security into two pieces. The percentage impact
of any unexpected losses on the junior piece, though, can be many times
greater than that on the whole security because any losses on the
underlying pool of loans will be absorbed by the smaller principal
amount of the junior security. (See Figure 1.)
Assume that most of the risk of credit loss for the $1,050 pool of
commercial loans described previously is concentrated in the bottom
$150 portion of the loans. The credit enhancement (the C piece) would
absorb the first $50 of losses. The $100 junior piece (i.e., Security
2B, the mezzanine position) would, therefore, contain the balance of
the credit risk of the $1,000 whole security. Since most of the credit
risk of the $1,000 whole security is concentrated in this junior piece,
for capital adequacy purposes, the appropriate dollar capital charge on
the $100 junior piece and the $1,000 security should, in theory, be
approximately the same. This would produce an equal capital buffer for
positions with approximately equal credit risk. On a percentage basis,
applying the same dollar capital charge against this mezzanine position
and the whole security results in a ten-times higher percentage
requirement on the mezzanine position than the ``face value'' option
because its face value is one-tenth the size of the whole security
($100 versus $1,000).
c. Concerns with Ratings Based on Expected Losses. The agencies
understand that some ratings are provided based on expected losses
(i.e., the sum of all the possible losses weighted by the probabilities
of their occurrence) rather than just the probability of default. This
approach takes into account both the severity and likelihood of losses,
and therefore addresses some of the problems presented by the
probability of default approach. Rating agencies that use the expected
loss approach require a small increase in the credit enhancement (the C
piece) supporting the junior piece (Security 2B) in order for this
piece to obtain the same credit rating as the whole security (Security
1). While this additional credit enhancement is required to account for
the concentration of credit risk in the junior piece, for risk-based
capital purposes, the enhancement may not fully compensate for this
concentration risk. (Figure 2)
d. Concerns About Modified Gross-up Proposal. There is some concern
that the additional capital that the modified gross-up approach
requires for certain situations may be disproportionate to the extent
to which ratings, in fact, fail to capture the concentration of risk in
mezzanine positions. In particular, for multi-tier securitizations that
have several investment grade tiers below the highest investment grade
rating, the modified gross-up approach may require too much capital
when all tiers are held in the banking system because each tier would
be grossed up and placed in the 50 percent risk weight category.
Example 4 illustrates this concern.
(Question 6). The agencies request comments comparing the face
value treatment with the modified gross-up treatment, and on other
refinements the agencies could consider to address their concerns
regarding the capital charge that would apply to thin-strip mezzanine
positions under the ratings-based approach.
(Question 7). For the modified gross-up approach, the agencies have
some concern that a 50 percent risk-weighting may be inappropriate to
apply to the grossed-up positions of securitizations. If this is the
case, what should the alternative risk weight be for the grossed-up
security and what data are available to support this alternative risk
weight?
(Question 8). For a thin-strip mezzanine position, a rating agency
that uses the expected losses approach requires a higher credit
enhancement to obtain a specified rating than a rating agency that uses
the probability of loss approach because the former takes into account
the loss severity of the position. Should the agencies have different
capital standards based on which of the two approaches is used for
determining the rating for the position?
BILLING CODE 4810-33-P
[[Page 59954]]
[GRAPHIC] [TIFF OMITTED] TP05NO97.000
BILLING CODE 4810-33-C
[[Page 59955]]
2. Examples of Face Value and Modified Gross-up Approaches
The capital requirements under the modified gross-up approach would
differ substantially from a face-value treatment. The modified gross-up
approach results in a higher capital requirement for thin-strip BBB-
rated mezzanine positions than the face value approach. On the other
hand, for senior BBB-rated positions, the modified gross-up approach
results in a lower capital requirement than the face value approach.
For instance, based on the example cited previously, the modified
gross-up approach for the $100 BBB-rated mezzanine position (Security
2B) would produce a capital charge of $40 (the grossed-up amount which
is equal to Security 2A plus Security 2B, $1,000, times 50 percent
times 8 percent) while the face value approach would produce a capital
requirement of $8 (the face amount of Security 2B, $100, times 100
percent times 8 percent). For the $1,000 senior BBB-rated position
(Security 1, the whole security), the modified gross-up approach would
produce a capital requirement of $40 ($1,000 times 50 percent times 8
percent) while the face value approach would produce a capital
requirement of $80 ($1,000 times 100 percent times 8 percent).
The four following examples illustrate, for various types of
securitization structures, the capital requirements for thrifts and
banks under current rules and under the proposed face value and
modified gross-up alternatives.
Example 1
Bank A issues three classes of securities that are backed by a
$100 million pool of loans. These classes include a bottom-level
(first-loss) subordinated class of $11 million, a publicly-traded
middle-level subordinated class of $9 million, and a publicly-traded
senior class of $80 million. Bank A retains the bottom-level class
and sells the other two classes to other banks or thrifts.
Under the face value and modified gross-up approaches, Bank A,
retaining the bottom-level subordinated class, would be required to
hold risk-based capital equal to 8 percent of the $100 million pool
or $8 million (the full effective risk-based capital requirement for
the outstanding amount of the assets enhanced). Assume that because
the subordinated class provides sufficient first dollar loss
enhancement, a nationally recognized statistical rating organization
gives the $9 million publicly-traded middle class the lowest
investment grade rating. Under the face value approach, the capital
requirement for an institution holding the position would be 8
percent of $9 million or $720 thousand. Under the modified gross-up
approach the capital requirement is 4 percent (50 percent times 8
percent) of the grossed-up amount of $89 million ($9 million plus
$80 million) or $3.56 million. Finally, assume that the $80 million
senior class receives the highest credit rating, which qualifies it
for a 20 percent risk weight under both approaches. The capital
requirement for an institution holding this piece would be 1.6
percent (20 percent times 8 percent) of $80 million or $1.28
million. Table 1 summarizes this example.
Table 1.--A-B-C Structure
[Underlying Assets--$100 million of Non-Mortgage Loans]
--------------------------------------------------------------------------------------------------------------------------------------------------------
Current Current
capital capital Face value Modified gross-
Position Size ($ Credit rating requirement requirement approach ($ up approach
mil) for thrifts for banks ($ mil) ($ mil)
($ mil) mil)
--------------------------------------------------------------------------------------------------------------------------------------------------------
A............................................ $80 AAA.......................... $6.40 $6.40 $1.28 $1.28
B............................................ 9 BBB.......................... 7.12 0.72 0.72 3.56
C............................................ 11 Unrated...................... 8.00 8.00 8.00 8.00
---------------------------------------------------------------
Total Capital............................ .......... ............................. 21.52 15.12 10.00 12.84
--------------------------------------------------------------------------------------------------------------------------------------------------------
Example 2
Bank A issues two classes of securities that are backed by a
$100 million pool of loans. These classes include a bottom-level
(first-loss) subordinated class of $20 million and a publicly-traded
senior class of $80 million. Bank A retains the bottom-level class
and sells the senior class to other banks or thrifts.
Under both the face value and the modified gross-up approaches,
Bank A, retaining the bottom-level subordinated class, would be
required to hold risk-based capital equal to 8 percent of the $100
million pool or $8 million (the full effective risk-based capital
requirement for the outstanding amount of the assets enhanced).
Assume that because the subordinated class provides sufficient first
dollar loss enhancement, a nationally recognized statistical rating
organization gives the $80 million publicly-traded senior class an A
rating. Under the face value approach, the capital requirement for
an institution holding position would be 8 percent of $80 million or
$6.4 million. Under the modified gross-up approach, the capital
requirement is 4 percent (50 percent times 8 percent) of the
grossed-up amount of $80 million (which, in this case, is the senior
piece) or $3.2 million. Table 2 summarizes this example.
Table 2.--A-B Structure
[Underlying Assets--$100 million of Non-Mortgage Loans]
--------------------------------------------------------------------------------------------------------------------------------------------------------
Current Current
capital capital Face value Modified gross-
Position Size ($ Credit rating requirement requirement approach ($ up approach
mil) for thrifts for banks ($ mil) ($ mil)
($ mil) mil)
--------------------------------------------------------------------------------------------------------------------------------------------------------
A............................................ $80 A............................ $6.40 $6.40 $6.40 $3.20
B............................................ 20 Unrated...................... 8.00 8.00 8.00 8.00
---------------------------------------------------------------
Total Capital............................ .......... ............................. 14.40 14.40 14.40 11.20
--------------------------------------------------------------------------------------------------------------------------------------------------------
Example 3
Bank A issues four classes of securities that are backed by a
$100 million pool of mortgage loans. These classes include a bottom-
level (first-loss) subordinated class of $0.75 million (the D
position), two thin publicly-traded middle-level subordinated
classes (the B and C positions, $1.5 and $0.75 million,
respectively), and a senior class of $97 million which meets the
requirements for a SMMEA security. Bank A retains the bottom-level
class and sells the other three
[[Page 59956]]
classes to banks or thrifts. (Under current rules, the Banking
Agencies apply a 100 percent risk weight to the B and C positions,
even though the underlying assets have a 50 percent risk weight,
because the B and C positions are subordinated.)
Under both the face value and the modified gross-up approaches,
Bank A, retaining the bottom-level subordinated class, would be
required to hold risk-based capital equal to 4 percent of the $100
million pool, limited to its $0.75 million maximum exposure (low-
level recourse). Assume that because the subordinated class provides
sufficient prior credit enhancement to the classes above it, a
nationally recognized statistical rating organization gives the two
publicly-traded middle classes ratings of BBB and A and the senior
class a rating of AAA. The capital requirements for the various
tranches are as follows. The current treatment for banks holding the
$97 million AAA-rated senior mortgage position is to apply a 50
percent risk weight to the position resulting in a capital
requirement of $3.88 million ($97 million times 50 percent times 8
percent). The current treatment for thrifts holding this $97 million
position is to apply a 20 percent risk weight to the position
resulting in a capital requirement of $1.552 million ($97 million
times 20 percent times 8 percent). Under both the face value and
modified gross-up approaches, the 20 percent risk weight would apply
to the $97 million position. For the two investment grade positions
below AAA (the B and C positions), the current thrift rules require
full gross-up of the positions and the resulting capital requirement
is subject to the low-level recourse rule that limits the
requirement to the size of the position. The modified gross-up
approach results in a capital requirement exceeding the size of the
position and would also be subject to the low-level rule. The
current bank rules, which use the face value approach, would apply a
100 percent risk weight to the position. Table 3 summarizes this
example.
Table 3--Multi-Tranche Structure
[Underlying Assets--$100 million of 50 percent Risk-Weight Mortgage Loans]
--------------------------------------------------------------------------------------------------------------------------------------------------------
Current Current
capital capital Face value Modified gross-
Position Size ($ Credit rating requirement requirement approach ($ up approach
mil) for thrifts for banks ($ mil) ($ mil)
($ mil) mil)
--------------------------------------------------------------------------------------------------------------------------------------------------------
A............................................ $97.0 AAA.......................... $1.552 $3.880 $1.552 $1.552
B............................................ 1.5 A............................ 1.500 0.120 0.120 1.500
C............................................ 0.75 BBB.......................... 0.750 0.060 0.060 0.750
D............................................ 10.75 Unrated...................... 0.750 0.750 0.750 0.750
Total Capital............................ .......... ............................. 4.552 4.810 2.482 4.552
--------------------------------------------------------------------------------------------------------------------------------------------------------
Example 4
A bank issues seven classes of securities (A through G) backed
by a $100 million pool of loans and retains a junior $6 million
subordinated interest. Additional credit enhancement available to
the class G securities enables those securities to obtain an A
rating. The other positions are rated as indicated in Table 4.
Table 4--Multi-Tranche Structure
[Underlying Assets--$100 million of Non-Mortgage Loans]
--------------------------------------------------------------------------------------------------------------------------------------------------------
Current Current
capital capital Face value Modified-gross-
Position Size ($ Credit rating requirement requirement approach ($ up approach
mil) for thrifts for banks ($ mil) ($ mil)
($ mil) mil)
--------------------------------------------------------------------------------------------------------------------------------------------------------
A............................................ $32 AAA.......................... $2.56 $2.56 0.51 0.51
B............................................ 21 AAA.......................... 4.24 1.68 0.34 0.34
C............................................ 17 AAA.......................... 5.60 1.36 0.27 0.27
D............................................ 6 AA........................... 6.00 0.48 0.48 3.04
E............................................ 6 A............................ 6.00 0.48 0.48 3.28
F............................................ 6 BBB.......................... 6.00 0.48 0.48 3.52
G............................................ 6 A............................ 6.00 0.48 0.48 3.76
Retained..................................... 6 Unrated...................... 6.00 6.00 6.00 6.00
Total Capital............................ .......... ............................. 42.40 13.52 9.04 20.72
--------------------------------------------------------------------------------------------------------------------------------------------------------
E. Alternative Approaches
1. Ratings Benchmark Approach
a. Description of Approach. Because of some concerns with the use
of the ratings-based approach for non-traded positions, the agencies
are considering another alternative--the ratings benchmark approach.
Under this alternative, the agencies would issue benchmark guidelines
that would be used in assessing the relative credit risk of non-traded
positions in specified standardized securitization structures. The
ratings benchmarks would set credit enhancement requirements and other
pool standards for such securitizations. If a non-traded position in
such a securitization fulfills the applicable standards, and the
securitization structure includes at least one traded position, the
non-traded position will be eligible for the same capital treatment as
investment-grade positions under the ratings-based approach.
The agencies are considering this approach: (1) To recognize and
build on consensus in the market regarding the amount of prior credit
enhancement and pool standards necessary to obtain an ``A'' rating from
the rating agencies; (2) To reduce the cost and regulatory burden of
requiring institutions to obtain ratings on non-traded positions in
such securitizations; and (3) To ensure that the agencies retain
supervisory discretion to supplement the rating agencies' standards by
adding criteria that the agencies consider essential to protect the
safe operation of insured institutions.
b. Development and Application of Ratings Benchmarks. The credit
enhancement requirements and other pool standards for each type of
securitization would be based on information available from the rating
agencies regarding the relative credit risk of various types of asset
pools. The ratings benchmark for each type of pool
[[Page 59957]]
would be based on the rating agencies' requirements for credit
enhancement and other pool standards necessary for the assignment of an
``A'' rating. Relying on the ``A'' rating standard provides assurance
of a level of credit quality and permits the use of a relatively simple
benchmark, while ensuring that the noninvestment-grade positions are
not given preferential capital treatment.
The agencies would limit the application of the ratings benchmark
approach to positions in a securitization structure in which there is
at least one traded position. This limitation is intended to ensure
that the pool standards imposed on securitizations by the rating agency
selected to rate the traded position would provide an extra measure of
protection reinforcing the agencies' benchmark standards.
To be eligible for the capital treatment under the ratings
benchmark approach, the benchmarks would require a specified amount of
prior credit enhancement based on the type of asset securitization
involved. Recourse arrangements and direct credit substitutes that fail
to satisfy the applicable benchmarks would be grossed-up.16
---------------------------------------------------------------------------
\16\ If a non-traded position failed to comply with any revised
benchmark standards for the specific asset type, the position would
be subject to the gross-up approach.
---------------------------------------------------------------------------
Under the ratings benchmark approach, qualifying prior credit
enhancements include: cash collateral accounts,17
subordinated interests or classes of securities; spread
accounts,18 including those funded initially with a loan
repaid from excess cash flow; and other forms of overcollateralization
involving excess cash flows (e.g., placing excess receivables into the
pool so that total cash flows expected to be received exceed cash flows
required to pay investors). These forms of credit enhancement are
consistent with the proposal contained in the 1994 Notice which defined
prior credit enhancement for the purposes of applying the multi-level
ratings based approach.
---------------------------------------------------------------------------
\17\ A cash collateral account is a separate account funded with
a loan from the provider of the credit enhancement. Funds in the
account are available to cover potential losses.
\18\ A spread account is typically a trust or special account
that the issuer establishes to retain interest rate payments in
excess of the sum of the amounts due investors from the underlying
assets, plus a normal servicing fee rate. The excess spread serves
as a cushion to cover potential losses on the underlying loans.
---------------------------------------------------------------------------
Consistent with comments received on the 1994 Notice and the types
of credit enhancement generally relied on by the ratings agencies in
rating asset pools, the agencies would also permit forms of prior
credit enhancement involving third-party performance risk.
Specifically, the agencies would permit: pool insurance, financial
guarantees, and standby letters of credit issued or guaranteed by
companies rated or whose debt is rated, in the highest two investment
categories by two rating agencies or similar rating organizations.
Third party credit enhancements would qualify under the ratings
benchmark approach if: (1) the credit enhancement absorbs credit losses
before an institution's non-traded position absorbs losses; and (2) the
credit enhancement represents an unconditional obligation of the third
party providing the enhancement.
c. Computation of Capital Requirements under the Ratings Benchmark
Approach. Non-traded positions in asset securitizations meeting the
benchmark standards would receive the same capital treatment as
investment grade positions under the ratings-based approach (i.e.,
either the face value treatment or the modified gross-up treatment).
Eligible positions would not be subject to the full gross-up treatment.
If the agencies have not developed a ratings benchmark for a
specific type of transaction, or if a position in a securitization
structure does not qualify under an established benchmark, the non-
traded position will be subject to the full gross-up approach, unless
it otherwise qualifies for the multi-level treatment under some other
approach for non-traded positions ultimately adopted in this
rulemaking.
d. Publication of Benchmarks. Initial benchmarks are provided for
securitizations backed by residential mortgages, credit cards, auto
loans, trade receivables, and commercial real estate. The prior credit
enhancement requirements and other pool standards contained in these
initial benchmarks have been based on discussions with rating agencies
and public information submitted to the agencies in this rulemaking.
19 Public comment is solicited on all aspects of the ratings
benchmark approach, including the standards contained in the
benchmarks.
---------------------------------------------------------------------------
\19\ See Duff and Phelps Credit Rating Company Presentation to
Federal Financial Institutions Examinations Council (April 18,
1995). This document is available for public review in the FFIEC
public reference room at 2100 Pennsylvania Avenue, NW., Suite 200
Washington, DC. The benchmarks in this document, however, do not
purport to reflect the current standards of that company or any
specific rating agency.
---------------------------------------------------------------------------
If the ratings benchmark approach is adopted, the agencies would
update the benchmarks at least once every two years based on a survey
of rating agencies. The revisions to the benchmarks for each asset type
would be based on the average of the two highest enhancement
requirements of the rating agencies responding to a survey.
Additionally, if this approach is adopted, the agencies would
establish new benchmarks for additional types of securitizations based
on continuing discussions with insured institutions and rating agencies
regarding appropriate pool standards and market developments. New
benchmarks would be issued only for types of securitizations for which
the agencies believe there is a market consensus on: (1) The amount of
prior credit enhancement; and (2) the pool standards that such
securitization positions generally must satisfy to obtain the
equivalent of an ``A'' rating from rating agencies.
The biennial changes to established benchmarks and the addition of
new benchmarks would be published for notice and comment in the Federal
Register. The publication would indicate the amount of credit
enhancement required for the type of securitization, and set forth
other pool standards and restrictions. After considering any comments,
the agencies would publish the revised benchmarks in the Federal
Register.
e. Implementation. The agencies may adopt all or part of this
approach without reproposal, as modified based on comments, in the
final rule issued in this rulemaking. In addition, if the agencies
adopt this approach in the final rule, they may initially implement the
approach on a smaller scale. For example, the approach may initially be
limited to use with securitizations backed by residential mortgages,
credit card or trade receivables. Non-traded positions in other types
of securitizations would either have to qualify for some other approach
adopted in the final rule or be subject to the full gross-up approach.
f. Benchmarks. Following are draft initial ratings benchmarks for
securitizations backed by residential mortgages, credit cards,
automobile loans, trade receivables, and commercial real estate.
[[Page 59958]]
Residential Mortgage-Backed Securities
----------------------------------------------------------------------------------------------------------------
``Rating Benchmark'' prior credit
Pool Type 1, 2 enhancement required for ``A'' rating Pool standards
----------------------------------------------------------------------------------------------------------------
30-year loans........................... 1.6 percent............................... Pools include at least 400
loans for each pool type.
15-year loans 0.8 percent............................... ..........................
Adjustable Rate Mortgages (ARMs) (1,5), 2.4 percent............................... No borrower concentration
(2,6). over 3 percent for each
pool type.
Hybrid loans (fixed-to-variable)........ 2.4 percent............................... ..........................
Balloon loans........................... 2.0 percent............................... ..........................
For no documentation and reduced
documentation loans, multiply the above
enhancements by 2.
For condominiums, two-to-four family, and
cooperative apartments, multiply the
above enhancements by 2.
For B and C loans, multiply the above
enhancements by 3.
For loan-to-value (LTV) ratios equal to or
below 80 percent:
--Use above enhancements..................
--Multiply above enhancements by 2, if
there is purchase mortgage insurance
(PMI) that brings loans below 80 percent.
For LTV ratios above 80 percent, multiply
the above enhancements by 4.
For the first five years of the
securitization, the above enhancement
requirement, as a percentage of the
outstanding principal, remains fixed. For
years six through ten, the enhancement
requirement would be multiplied by 0.75.
Beyond ten years, the enhancement would
be multiplied by 0.5 3, 4 .
----------------------------------------------------------------------------------------------------------------
\1\ For positions that represent less than 10 percent of the size of the underlying pool of loans, add 20
percent to the enhancement level.
\2\ For closed-end second mortgage securities, determine the LTV ratio of the loans in the security and apply
the enhancement requirements for the underlying collateral. In addition, change the 15-year enhancement
requirement to 1.6 percent due to increased risk of security.
\3\ The reduction in the multiplier over time reflects the reduced risk of the mortgage portfolio due to
seasoning.
\4\ For a six-year old 15-year mortgage-backed security backed by B and C loans that have LTV ratios above 80
percent, the enhancement would be 0.8 percent x 3 x 4 x 0.75 = 7.2 percent.
Asset-Backed Securities
----------------------------------------------------------------------------------------------------------------
``Rating Benchmark'' prior credit
Pool Type \1\ enhancement required for ``A'' rating Pool standards
----------------------------------------------------------------------------------------------------------------
Credit cards \2\........................ The higher of 6 percent or 1.2 times Enhancement has access to
lagged charge-off rate \3\. excess spread.
Auto Loans:.............................
Prime (A type)...................... 7.0 percent............................... Sellers of automobile
loans must have at least
three years of historical
information.
Sub-prime (B, C, and D types)....... The higher of 15.0 percent or 3 times net Enhancement has access to
expected loss rate \4\. excess spread.
Trade Receivables....................... 12.0 percent per loan pool \5\ (if all Pools may not have seller
sellers of trade receivables are rated 1 concentrations above 5
or 2) 18.0 percent per loan pool \5\ (if percent of pool amount.
any seller of trade receivables is rated
3 or 4 and no lower than 4).
.......................................... Based on Federal Reserve
Board rating criteria for
trade receivables, each
seller must be rated
between 1 and 4.
The above enhancements will remain fixed For credit cards and auto
as a percentage of outstanding principal, loans, pool must be
with a floor of 3 percent of original randomly selected and
principal. nationally-diversified.
----------------------------------------------------------------------------------------------------------------
\1\ For positions that represent less than 10 percent of the size of the underlying pool of loans, add 20
percent to the credit enhancement level.
\2\ Credit cards include home equity lines of credit that are similar to credit card loans.
\3\ Lagged charge-off rate is based on the monthly average of past six month's charge-offs, multiplied by
twelve, then divided by the average outstanding balance from a year ago.
\4\ Net expected loss rate is the monthly average of last quarter's gross default amount netted against
recoveries, multiplied by twelve, then divided by the average outstanding loan balance for the last quarter.
\5\ Overcollateralization amount would count toward credit enhancement.
Commercial Mortgage-Backed Securities
----------------------------------------------------------------------------------------------------------------
``Rating Benchmark'' prior credit
Pool type \1\ enhancement required for ``A'' rating Pool standards
----------------------------------------------------------------------------------------------------------------
Office.................................. 26.0 percent.............................. Debt-service coverage at
least 1.25
[[Page 59959]]
Regional Mall........................... 10.0 percent.............................. Debt-service coverage at
least 1.35
Industrial/Anchored Retail.............. 13.0 percent.............................. Debt-service coverage at
least 1.35
Multifamily............................. 17.0 percent.............................. Debt-service coverage at
least 1.25
The above enhancements are for pools of For each type of pool
loan
