[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]

[[Page 59943]]

_______________________________________________________________________

Part II

Department of the Treasury
Office of the Comptroller of the Currency

12 CFR Part 3

Federal Reserve System

12 CFR Parts 208 and 225

Federal Deposit Insurance Corporation

12 CFR Part 325

Department of the Treasury
Office of Thrift Supervision

12 CFR Part 567

_______________________________________________________________________

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.

ACTION: Joint notice of proposed rulemaking.

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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:
    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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    Treat recourse obligations and direct credit substitutes
consistently for risk-based capital purposes; and
    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:
    Use criteria developed by the agencies, based on the
criteria of the rating agencies, to determine the capital requirements;
or
    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:
    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.
    The capital treatment does not recognize differences in
risk associated with different loss positions in asset securitizations.
    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:
    Define recourse and revise the definition of direct credit
substitute (See section II.A of this preamble);
    Treat recourse obligations and direct credit substitutes
consistently for risk-based capital purposes (See section II.B of this
preamble); and
    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:
    Use criteria developed by the agencies, based on the
criteria of the rating agencies, to determine the capital requirements;
or
    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.''

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[[Page 59948]]

   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
---------------------------------------------------------------------------

   \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.
---------------------------------------------------------------------------

    A position rated in the highest investment grade rating
category would receive a 20 percent risk weight.
    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.)
    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
---------------------------------------------------------------------------

   \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
---------------------------------------------------------------------------

   \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
                                          loans with loan-to-value ratios less than   above:
                                          or equal to 70 percent. For pools of       --No borrower
                                          loans with greater than 70 percent loan-    concentration over 5
                                          to-value ratio, multiply the above          percent of pool amount.
                                          enhancements by 1.5.                       --The amortization
                                                                                      schedule does not exceed
                                                                                      25 years.
                                         For pools with property quality below the
                                          B level, multiply the above enhancements
                                          by 1.5.
                                         The above enhancements will remain fixed
                                          as a percentage of outstanding principal,
                                          with a floor of 3 percent of original
                                          principal \2\..
----------------------------------------------------------------------------------------------------------------
\1\ For positions that represent less than 10 percent of the underlying pool of loans, add 20 percent to the
 credit enhancement level.
\2\ For example, the enhancement for a security containing regional mall loans with an 80 percent LTV ratio and
 B quality property would be 10 percent x 1.5 x 1.5 = 22.5 percent.

   g. Examples. To determine the dollar amount of prior credit
enhancement required for a non-traded position of a securitization, the
percentages shown in the benchmarks would be applied to the outstanding
amount of the underlying loans in the securitization and monitored
regularly by the regulatory agencies and by institutions. For example,
for residential mortgage loans, the credit enhancement for a non-traded
securitization position must be maintained at the outstanding principal
level multiplied by 100 percent of the benchmark level for years one
through five. For years six through ten, the required enhancement would
be set at 75 percent of the benchmark level. For years eleven and
beyond the enhancement requirement would be set at 50 percent of the
benchmark level.20
---------------------------------------------------------------------------

   \20\ The reduction in the required credit enhancement amount
over time is due to the reduced credit risk of seasoned mortgage
loan pools.
---------------------------------------------------------------------------

   Example of a Residential Mortgage Securitization. Assume an
institution has provided a 3 percent guarantee on a $6 million
mezzanine position of a $200 million residential mortgage
securitization. The junior position is a $10 million piece held by a
second institution. The underlying mortgages are 15-year fixed-rate
``B'' and ``C'' residential mortgage loans with no greater than 70
percent loan-to-value ratios (LTV), with no private mortgage insurance.
The benchmark requirement would be 0.8 percent (15-year mortgages)
times 1 (70 percent LTV ratio) times 3 (``B'' and ``C'' loans) or 2.4
percent of the securitization amount of $200 million, which equals $4.8
million. Since the $10 million junior position exceeds $4.8 million,
the guarantee would not be subject to the gross-up approach.
   After one year, losses on the pool are $2 million and the size of
the pool decreases to $190 million. The benchmark requirement would be
2.4 percent of $190 million or $4.5 million. Since the junior piece of
$8 million still exceeds $4.5 million, the guarantee would still not be
subject to the gross-up approach.
   Example of a Credit Card Securitization. Assume an institution has
provided a guarantee for the bottom 15 percent of a $100 million credit
card securitization. This bottom position is unrated. A third party
provides a cash collateral account of 7 percent or $7 million in front
of the unrated position. Because the pool is new, the institution must
project the annual loss experience on the pool.21 In this
case, it projects 4 percent. Based on the benchmarks, the 4 percent
should be multiplied by 1.2 and then compared with 6 percent to
determine which of the two numbers is higher. Since 6 percent is
higher, the benchmark requirement becomes 6 percent of $100 million or
$6 million. Since the cash collateral account of $7 million exceeds 6
percent of $100 million, the guarantee would receive a risk weight that
is lower than under the gross-up approach.
---------------------------------------------------------------------------

   \21\ If the institution has experience with this type of pool,
then this historical experience should be used to determine the loss
rate required to determine the benchmark.
---------------------------------------------------------------------------

   After one year, the pool of credit card loans decreases to $80
million. The experience on these credit card loans indicates that the
lagged loss rate of the loans is 7 percent of the pool, not 4 percent
as projected. In addition, assume the cash collateral account provided
by the third party decreases to $5 million net of excess cash flows and
pool losses. The benchmark is the higher of 6 percent or 8.4 percent
(1.2 times 7 percent). The 8.4 percent benchmark is applied to the $80
million pool resulting in a required enhancement of $6.7 million. Since
this exceeds the $5 million cash collateral account, the gross-up
approach would be applied to the guarantee. To avoid the fully-grossed-
up treatment, the third party would need to increase the cash
collateral account by $1.7 million to $6.7 million.
   Example of a Trade Receivable Securitization. Assume an institution
has provided a guarantee on the bottom 12 percent portion of an asset-
backed commercial paper program. All of the seller programs within the
structure are rated 1 or 2 by the regulator. No program within the
structure represents more than 5 percent of the pool and each program
within the pool has 15 percent overcollateralization. The guarantee on
this commercial paper program would not be grossed up because it is
well-diversified, all programs are rated 1 or 2, and the over-
collateralization exceeds 12 percent.
   Assume that after six months, two of the pool's
overcollateralization levels decrease to 10 percent and one of the
seller programs is rated 3. The guarantee would be subject to the
gross-up

[[Page 59960]]

approach for either of two reasons. First, none of the seller programs
have 18 percent collateral, which is the new requirement based on the
one program that is rated 3. Second, even if the one program was not
rated 3, the two programs with 10 percent collateral do not meet the 12
percent collateral requirement for 1- and 2-rated seller programs.
   (Question 9) What changes, if any, should be made to the amounts of
prior credit enhancement and the pool standards required by the
agencies' benchmarks? Please provide supporting information, if
available.
   (Question 10) Can the benchmark standards be simplified without
unduly relaxing the protection afforded to institutions by these
standards?
   (Question 11) What additional types of pools and securitization
transactions are sufficiently standardized and homogenous to permit the
agencies to develop reliable benchmarks? Would it be reasonable to
handle these securitizations on a case-by-case basis using the best
available data from the rating agencies at the time of the
securitization?
   (Question 12) Is the biennial review and update of the benchmarks
appropriate?
   (Question 13) Please comment on ways the agencies could most
effectively evaluate and monitor institutions' use of ratings
benchmarks in the examination process with the least possible burden on
institutions and examiners.
   (Question 14) Should the agencies adopt both the ratings-based
approach and ratings benchmark approach for non-traded positions?
Alternatively, should the agencies adopt only one of these approaches
for non-traded positions in rated securitizations?
   (Question 15) If the agencies decide to adopt both approaches,
should institutions be given the discretion to elect which of these
approaches to use for their non-traded positions? On the other hand, if
the agencies adopt the ratings benchmark approach, should the ratings-
based approach be used for non-traded positions in securitizations for
which a benchmark has not been developed?
   (Question 16) Please compare the relative financial and operational
burdens that would be imposed on institutions by the ratings-based
approach and ratings benchmark approach for non-traded positions.
2. Internal Information Approaches
   In response to the 1994 Notice, the agencies also received several
comments proposing approaches under which an institution would use
credit information it has about the underlying assets to set the
capital requirement for a position. These commenters observed that
evaluating credit risks is a traditional area of bank expertise and
that an institution knows its own assets better than anyone else.
   The agencies agree that using the information that institutions
have about the credit quality of assets underlying a position could, if
feasible, be more efficient than any of the ratings-based approaches
for assessing capital requirements on non-traded positions. Therefore,
the agencies are considering two approaches based on this type of
information: the ``historical loss'' approach and the ``bank model''
approach. The agencies may adopt all or part of this historical loss
approach in the final rule adopted in this rulemaking without
reproposal. Accordingly, the agencies solicit comments and supporting
information to aid in their development of the historical loss and bank
model approaches.
   a. Historical Loss Approach. A principal purpose of regulatory
capital is to provide a cushion against unexpected losses. The
historical loss approach being considered by the agencies would take
unexpected losses over the life of the asset pool into account. These
losses may not be taken into account fully in the ratings-based
approaches. The historical loss approach, however, bases the risk-based
capital treatment for a position in a securitization on the
characteristics of the underlying pool of assets, including the
variance of losses. This variance is the source of unexpected losses.
While the historical loss approach could, in theory, be used for all
recourse obligations and direct credit substitutes, the agencies are
proposing that the approach initially be applied only to non-traded
positions in securitizations with at least one traded position.
   To measure the variance of losses on a pool of assets, an
institution would have to project the probability distribution of the
cumulative losses on the underlying assets over the life of the pool
based on historical loss information for assets comparable to those in
the pool. Comparability would encompass such factors as credit quality,
collateral, and repayment terms. The cumulative losses would be the
portion of the assets in the pool that would not be recovered over the
life of the pool.
   Under this approach, the risk-based capital treatment for a non-
traded position would depend on the expected value of losses on the
underlying pool, plus a specified number of standard deviations. As a
general rule, at the inception of a securitization, the holder or
issuer of a non-traded position would determine whether the holder
would incur a loss if the cumulative losses on the underlying assets in
the pool reached the expected value of losses plus the designated
number of standard deviations (e.g., expected loss plus five standard
deviations for normal distributions). This determination would consider
any available qualifying credit enhancements providing support to the
position and the existence of any more junior positions in the
securitization.
   Thus, the expected value of losses plus the designated number of
standard deviations would serve as a boundary. If the holder of a non-
traded position would suffer a loss when the level of cumulative losses
on the underlying assets in the pool reached this boundary, then the
position would receive the gross-up treatment. The institution's
capital requirement, however, would be subject to the low-level rule.
Otherwise, the position would qualify to be treated in the same manner
as traded positions with ratings below ``AAA'' under the multi-level,
ratings-based approach. In short, the non-traded position would qualify
to use either the face value treatment or the ``modified gross-up''
approach, depending upon which of these proposed alternatives the
agencies adopt in their final rules (see sections II.C and II.D of this
preamble). An institution's estimate of the probability distribution,
measurement of the variance, assessment of the support provided by
credit enhancements, and determination of the loss exposure on a non-
traded position, as well as the resulting risk-based capital treatment
of the position, would be subject to review by examiners.
   In projecting the probability distribution of the losses on a
pool's underlying assets, an institution would need to compile and
analyze historical loss information for individual assets that are
comparable to those in the pool. This would include considering the
size of the losses on individual assets and, depending on the type of
credit enhancement supporting the securitization, the amount of time
after the origination of the type of assets being securitized when
losses generally occur on that asset type. This information may be
available from the information the issuer supplies to the rating
agencies for their use in rating the securitization's traded positions.
   The agencies are proposing that the types of credit enhancement
that would qualify to be considered when determining whether the holder
of a

[[Page 59961]]

non-traded position would incur any losses be the same as those
proposed under the ratings benchmark approach. The size or availability
of one or more of the credit enhancements in a securitization (e.g., a
spread account), however, may vary over time based on the performance
of the pool's underlying assets. If such a credit enhancement supports
one or more of the positions in a securitization, the institution also
would need to consider the shape of the loss curve over the life of the
pool that produces cumulative losses over that period equal to the
expected value of losses, plus the designated number of standard
deviations. In this situation, as a supplement to the general rule
cited previously, the size of the credit enhancement that would be
available at any point over the life of the pool given the loss curve's
indicated level of losses would need to be sufficient to prevent the
holder of a non-traded position from suffering a loss in order for the
non-traded position to avoid application of the gross-up approach.
   As an example of the application of this historical loss approach,
assume an institution owns a non-traded $100 subordinated piece of a
$1,000 securitized asset pool. A qualifying standby letter of credit
issued by a bank will absorb the first $20 of losses for the pool,
thereby providing partial protection to the institution's subordinated
position. For asset pools of this type, the institution determines that
the expected value of losses plus the designated number of standard
deviations over the life of the pool is $80. Given the size of the
credit enhancement, the institution will sustain a loss of $60 on its
subordinated interest if pool losses reach the expected value of
losses, plus the designated number of standard deviations. Therefore,
the institution's position would be subject to the gross-up approach.
Capital would be held for the institution's position plus all more
senior positions. After considering the $20 qualifying standby letter
of credit (which would be treated as a bank guarantee on part of the
pool) and assuming the assets in the pool are risk-weighted at 100
percent, the risk-based capital charge for the subordinated piece would
be $78.72 [($20 x 20 percent x 8 percent) + ($980 x 100 percent x 8
percent)].
   In contrast, if the expected value of losses plus the designated
number of standard deviations over the life of the pool in the
preceding example were only $19, the $20 credit enhancement would fully
absorb those losses and the institution would not expect to incur any
losses on its subordinated position. The institution's position would
qualify for the capital treatment applicable to traded investment-grade
positions rated below ``AAA.''
   Based on discussions with market participants, the agencies believe
that those institutions that are active in the securitization business
will normally possess historical loss data for assets comparable to
those they are securitizing. In this regard, these institutions must be
capable of measuring and monitoring the credit risk they have retained
or assumed in securitizations to conduct their securitization
activities in a safe and sound manner. If an institution were unable to
do the statistical analysis necessary to implement this proposed
historical loss approach, however, its non-traded positions would be
subject to the gross-up approach.
   (Question 17) Given the varying number of years in the life of a
pool for different types of assets, what is the minimum number of years
of historical loss data that should be used to project the probability
distribution of the cumulative losses on each type of underlying asset
pool over the pool's life? If information for the minimum number of
years is not available, is it reasonable for institutions to be
required to apply the gross-up approach to non-traded positions?
   (Question 18) How should institutions determine whether the capital
requirement for a non-traded position should be changed over time?
Should institutions periodically adjust the loss distribution that they
used to set their initial capital requirement to reflect actual losses
on pool assets over the life of the pool?
   (Question 19) Is it reasonable for the agencies to use a log normal
curve to describe the distribution of losses on a pool of assets? Would
another approach be preferable and, if so, why would it be preferable?
   (Question 20) Would this approach be applicable to all asset types
or are there some asset types with unusual characteristics for which
this approach would be inappropriate?
   (Question 21) How burdensome would this historical loss approach be
for institutions? To what extent is the necessary loss data available?
What modifications should the agencies consider making as they develop
this approach?
   b. Bank Model Approach. Commenters on the 1994 Notice suggested
that the capital requirements for recourse obligations and direct
credit substitutes also could be based on internal risk assessments
made by banks holding those positions. Over the past decade, some
banking organizations have developed, for their own internal risk
management purposes, statistical techniques for quantifying the credit
risk in sub-portfolios of credit instruments such as direct credit
substitutes. In principle, these ``internal models'' for measuring
credit risk could be used in setting capital requirements for direct
credit substitutes and possibly other credit positions. Such a system
would be broadly consistent with both the internal models approach to
capital now being implemented for market risks associated with bank
trading activities, as well as with current supervisory policies for
evaluating the adequacy of the allowance for loan and lease losses.
   Currently, the agencies are uncertain whether an internal model
approach is feasible. However, the agencies recognize that the
development of an internal model approach to capital for direct credit
substitutes, and perhaps for other credit instruments, could have
significant benefits. For example, under the ratings approach, a bank's
internal risk assessment--if acceptable to supervisors--might
substitute for a credit rating, thus reducing costs and delays
associated with obtaining credit ratings. Alternatively, an acceptable
internal model for measuring credit risk might form the basis for
assessing capital requirements on a portfolio basis rather than on an
asset-by-asset basis, thus better reflecting a bank's diversification
and hedging activities.
   The agencies note that securitization activities can create
positions that add significantly to the volatility, appropriately
measured, of an institution's credit losses. Banks for which such
activities are significant should have in place appropriate policies
and practices to quantify and manage the credit risk associated with
securitization. The agencies, as always, will review the quality of
such policies and practices within the context of evaluating the
overall quality of a bank's risk management processes.
   (Question 22) Is an internal model approach to setting capital
requirements for recourse, direct credit substitutes, and other credit
instruments currently feasible and, if so, how might it be structured?
   (Question 23) Which types of credit activities would be amenable to
such an approach?
   (Question 24) How could the agencies validate such internal models
and their credit risk assessments?

III. Regulatory Flexibility Act

   OCC: Pursuant to section 605(b) of the Regulatory Flexibility Act,
the OCC

[[Page 59962]]

certifies that this proposal will not have a significant impact on a
substantial number of small entities. 5 U.S.C. 601 et seq. The
provisions of this proposal that increase capital requirements are
likely to affect large banks almost exclusively. (Small banks are
unlikely to be in a position to provide direct credit substitutes in
asset securitizations.) Accordingly, a regulatory flexibility analysis
is not required.
   Board: Pursuant to section 605(b) of the Regulatory Flexibility
Act, the Board does not believe this proposal will have a significant
impact on a substantial number of small business entities in accord
with the spirit and purposes of the Regulatory Flexibility Act (5
U.S.C. 601 et seq.). The Board's comparison of the applicability
section of this proposal with Call Report Data on all existing banks
shows that application of the rule to small entities will be the rare
exception. Accordingly, a regulatory flexibility analysis is not
required. In addition, because the risk-based capital standards
generally do not apply to bank holding companies with consolidated
assets of less than $150 million, this rule will not affect such
companies.
   FDIC: Pursuant to section 605(b) of the Regulatory Flexibility Act
(Pub. L. 96-354, 5 U.S.C. 601 et seq.), the FDIC certifies that the
proposed rule will not have a significant impact on a substantial
number of small entities. Comparison of Call Report data on FDIC-
supervised banks to the items covered by the proposal that result in
increased capital requirements shows that application of the rule to
small entities will be the infrequent exception.
   OTS: Pursuant to section 605(b) of the Regulatory Flexibility Act,
the OTS certifies that this proposal will not have a significant impact
on a substantial number of small entities. The proposal is likely to
reduce slightly the risk-based capital requirements for recourse
obligations and direct credit substitutes, except for some standby
letters of credit. Thrifts currently issue few, if any, standby letters
of credit. Accordingly, a regulatory flexibility analysis is not
required.

IV. Paperwork Reduction Act

   Board: In accordance with the Paperwork Reduction Act of 1995 (44
U.S.C. Ch. 3506; 5 CFR 1320 Appendix A.1), the Board reviewed the
proposed rule under the authority delegated to the Board by the Office
of Management and Budget. No collections of information pursuant to the
Paperwork Reduction Act are contained in the proposed rule.

V. Executive Order 12866

   OCC: On the basis of the best information available, the OCC has
determined that this proposal is not a significant regulatory action
for purposes of Executive Order 12866. However, the impact of any final
rule resulting from this proposal will depend on factors for which the
agencies do not currently collect industry-wide information, such as
the proportion of bank-provided direct credit substitutes that would be
rated below investment grade. The OCC therefore welcomes any
quantitative information national banks wish to provide about the
impact they expect the various portions of this proposal to have if
issued in final form.
   OTS: The Director of the OTS has determined that this proposal does
not constitute a ``significant regulatory action'' under Executive
Order 12866. The proposal is likely to reduce slightly the risk-based
capital requirements for recourse obligations and direct credit
substitutes, except for some standby letters of credit. Thrifts
currently issue few, if any, standby letters of credit. As a result,
the OTS has concluded that the proposal will have only minor effects on
the thrift industry.

VI. OCC and OTS--Unfunded Mandates Reform Act of 1995

   Section 202 of the Unfunded Mandates Reform Act of 1995 (Unfunded
Mandates Act), requires that an agency prepare a budgetary impact
statement before promulgating a rule that includes a Federal mandate
that may result in the expenditure by state, local, and tribal
governments, in the aggregate, or by the private sector, of $100
million or more in any one year. If a budgetary impact statement is
required, section 205 of the Unfunded Mandates Act also requires an
agency to identify and consider a reasonable number of regulatory
alternatives before promulgating a rule. The OCC and OTS have
determined that this proposal will not result in expenditures by state,
local, and tribal governments, or by the private sector, of more than
$100 million or more in any one year. Therefore, the OCC and OTS have
not prepared a budgetary impact statement or specifically addressed the
regulatory alternatives considered. As discussed in the preamble, this
proposal rule will correct certain inconsistencies in the agencies'
risk-based capital standards and will allow banking organizations to
maintain lower amounts of capital against certain rated recourse
obligations and direct credit substitutes.

List of Subjects

12 CFR Part 3

   Administrative practice and procedure, Capital, National banks,
Reporting and recordkeeping requirements, Risk.

12 CFR Part 208

   Accounting, Agriculture, Banks, banking, Confidential business
information, Crime, Currency, Federal Reserve System, Mortgages,
Reporting and recordkeeping requirements, Securities.

12 CFR Part 225

   Administrative practice and procedure, Banks, banking, Federal
Reserve System, Holding companies, Reporting and recordkeeping
requirements, Securities.

12 CFR Part 325

   Administrative practice and procedure, Banks, banking, Capital
adequacy, Reporting and recordkeeping requirements, Savings
associations, State non-member banks.

12 CFR Part 567

   Capital, Reporting and recordkeeping requirements, Savings
associations.

Office of the Comptroller of the Currency

12 CFR Chapter I

Authority and Issuance

   For the reasons set out in the preamble, appendix A of part 3 of
chapter I of title 12 of the Code of Federal Regulations is proposed to
be amended as follows:

PART 3--MINIMUM CAPITAL RATIOS; ISSUANCE OF DIRECTIVES

   1. The authority citation for part 3 continues to read as follows:

   Authority: 12 U.S.C. 93a, 161, 1818, 1828(n), 1828 note, 1831n
note, 1835, 3907 and 3909.

   2. In part 3, appendix A, section 3, paragraph (b) is amended by
adding a new sentence at the end of the introductory text; paragraph
(b)(1)(i) and footnote 13 are removed and reserved; paragraph
(b)(1)(ii) is revised; paragraph (b)(1)(iii) and footnote 14 are
removed and reserved; footnote 16 in paragraph (b)(2)(i) and footnote
17 in paragraph (b)(2)(ii) are revised; and paragraph (d) is revised to
read as follows:

Appendix A to Part 3--Risk-Based Capital Guidelines

* * * * *

[[Page 59963]]

Section 3. Risk Categories/Weights for On-Balance Sheet Assets and
Off-Balance Sheet Items

* * * * *
   (b) * * * However, direct credit substitutes, recourse
obligations, and securities issued in connection with asset
securitizations are treated as described in section 3(d) of this
appendix A.
   (1) * * *
   (ii) Risk participations purchased in bankers' acceptances.
* * * * *
   (2) * * *
   (i) * * * 16* * *
---------------------------------------------------------------------------

   \16\ Participations in performance-based standby letters of
credit are treated in accordance with section 3(d) of this appendix
A.
---------------------------------------------------------------------------

   (ii) * * * 17* * *
---------------------------------------------------------------------------

   \17\ Participations in commitments are treated in accordance
with section 3(d) of this appendix A.
---------------------------------------------------------------------------

* * * * *
   (d) Recourse obligations, direct credit substitutes, and asset-
and mortgage-backed securities. (1) Definitions. For purposes of
this section 3 of this appendix A:
   (i) Direct credit substitute means an arrangement in which a
national bank assumes, in form or in substance, any risk of credit
loss directly or indirectly associated with a third-party asset or
other financial claim, that exceeds the national bank's pro rata
share of the asset or claim. If a national bank has no claim on the
asset, then the assumption of any risk of credit loss is a direct
credit substitute. Direct credit substitutes include, but are not
limited to:
   (A) Financial guarantee-type standby letters of credit that
support financial claims on the account party;
   (B) Guarantees, surety arrangements, and irrevocable guarantee-
type instruments backing financial claims;
   (C) Purchased subordinated interests or securities that absorb
more than their pro rata share of losses from the underlying assets;
   (D) Loans or lines of credit that provide credit enhancement for
the financial obligations of an account party; and
   (E) Purchased loan servicing assets if the servicer is
responsible for credit losses associated with the loans being
serviced (other than servicer cash advances as defined in section
3(d)(1)(v) of this appendix A), or if the servicer makes or assumes
representations and warranties on the loans (other than standard
representations and warranties as defined in section 3(d)(1)(vi) of
this appendix A).
   (ii) Financial guarantee-type standby letter of credit means any
letter of credit or similar arrangement, however named or described,
which represents an irrevocable obligation to the beneficiary on the
part of the issuer:
   (A) To repay money borrowed by, or advanced to, or for the
account of, an account party; or
   (B) To make payment on account of any indebtedness undertaken by
an account party, in the event that the account party fails to
fulfill its obligation to the beneficiary.
   (iii) Rated means, with respect to an instrument or obligation,
that the instrument or obligation has received a credit rating from
a nationally-recognized statistical rating organization. An
instrument or obligation is rated investment grade if it has
received a credit rating that falls within one of the four highest
rating categories used by the nationally-recognized statistical
rating organization. An instrument or obligation is rated in the
highest investment grade category if it has received a credit rating
that falls within the highest investment grade category used by the
nationally-recognized statistical rating organization.
   (iv) Recourse means the retention in form or substance of any
risk of credit loss directly or indirectly associated with a
transferred asset that exceeds a pro rata share of a national bank's
claim on the asset. If a national bank has no claim on a transferred
asset, then the retention of any risk of credit loss is recourse. A
recourse obligation typically arises when an institution transfers
assets and retains an obligation to repurchase the assets or to
absorb losses due to a default of principal or interest or any other
deficiency in the performance of the underlying obligor or some
other party. Recourse may exist implicitly where a bank provides
credit enhancement beyond any contractual obligation to support
assets it has sold. Recourse obligations include, but are not
limited to:
   (A) Representations and warranties on the transferred assets
(other than standard representations and warranties as defined in
section 3(d)(1)(vi) of this appendix A);
   (B) Retained loan servicing assets if the servicer is
responsible for losses associated with the loans serviced (other
than a servicer cash advance as defined in section 3(d)(1)(v) of
this appendix A);
   (C) Retained subordinated interests or securities that absorb
more than their pro rata share of losses from the underlying assets;
   (D) Assets sold under an agreement to repurchase; and
   (E) Loan strips sold without direct recourse where the maturity
of the transferred loan is shorter than the maturity of the
commitment.
   (v) Servicer cash advance means funds that a residential
mortgage loan servicer advances to ensure an uninterrupted flow of
payments or the timely collection of residential mortgage loans,
including disbursements made to cover foreclosure costs or other
expenses arising from a mortgage loan to facilitate its timely
collection. A servicer cash advance is not a recourse obligation or
a direct credit substitute if:
   (A) The mortgage servicer is entitled to full reimbursement; or
   (B) For any one mortgage loan, nonreimbursable advances are
contractually limited to an insignificant amount of the outstanding
principal on that loan.
   (vi) Standard representations and warranties means contractual
provisions that a national bank extends when it transfers assets
(including loan servicing assets), or assumes when it purchases loan
servicing assets. To qualify as a standard representation or
warranty, a contractual provision must:
   (A) Refer to facts that the seller or servicer can verify, and
has verified with reasonable due diligence, prior to the time that
assets are transferred (or servicing assets are acquired);
   (B) Refer to a condition that is within the control of the
seller or servicer; or
   (C) Provide for the return of assets in the event of fraud or
documentation deficiencies.
   (vii) Traded position means a recourse obligation, direct credit
substitute, or asset- or mortgage-backed security that is retained,
assumed, or issued in connection with an asset securitization and
that was rated with a reasonable expectation that, in the near
future:
   (A) The position would be sold to investors relying on the
rating; or
   (B) A third party would, in reliance on the rating, enter into a
transaction such as a purchase, loan or repurchase agreement
involving the position.
   (2) Risk-weighted asset amount. Except as otherwise provided in
sections 3(d)(3) and (4) of this appendix A, to calculate the risk-
weighted asset amount for a recourse obligation or direct credit
substitute, multiply the amount of assets from which risk of credit
loss is directly or indirectly retained or assumed, by the
appropriate risk weight using the criteria regarding obligors,
guarantors, and collateral listed in section 3(a) of this appendix
A. For purposes of this section 3(d) of this appendix A, the amount
of assets from which risk of credit loss is directly or indirectly
retained or assumed means:
   (i) For a financial guarantee-type standby letter of credit,
surety arrangement, guarantee, or irrevocable guarantee-type
instrument, the amount of the assets that the direct credit
substitute fully or partially supports;
   (ii) For a subordinated interest or security, the amount of the
subordinated interest or security plus all more senior interests or
securities;
   (iii) For mortgage servicing rights that are recourse
obligations or direct credit substitutes, the outstanding amount of
the loans serviced;
   (iv) For representations and warranties (other than standard
representations and warranties), the amount of the assets subject to
the representations or warranties;
   (v) For loans on lines of credit that provide credit enhancement
for the financial obligations of an account party, the amount of the
enhanced financial obligations;
   (vi) For loans strips, the amount of the loans; and
   (vii) For assets sold with recourse, the amount of assets from
which risk of credit loss is directly or indirectly retained or
assumed, less any applicable recourse liability account established
in accordance with generally accepted accounting principles.
   (3) Investment grade recourse obligations, direct credit
substitutes, and asset-and mortgage-backed securities. (i)
Eligibility. A traded position is eligible for the treatment
described in this section 3(d)(3) of this appendix A if it has been
rated investment grade by a nationally-recognized statistical rating
organization. A recourse obligation or direct credit substitute that
is not a traded position is eligible for the treatment described in
this section 3(d)(3) of this

[[Page 59964]]

appendix A if it has been rated investment grade by two nationally-
recognized statistical rating organizations, the ratings are
publicly available, the ratings are based on the same criteria used
to rate securities sold to the public, and the recourse obligation
or direct credit substitute provide credit enhancement to a
securitization in which at least one position is traded.
   (ii) Highest investment grade. To calculate the risk-weighted
asset amount for a recourse obligation, direct credit substitute, or
asset-or mortgage-backed security that is rated in the highest
investment grade category, multiply the face amount of the position
by a risk weight of 20 percent.
   (iii) Other investment grade.
   [Option 1--Face Value Treatment] To calculate the risk-weighted
asset amount for a recourse obligation, direct credit substitute, or
asset- or mortgage-backed security that is rated investment grade,
multiply the face amount of the position by a risk weight of 100
percent.
   [Option 2--Modified Gross-Up] To calculate the risk-weighted
asset amount for a recourse obligation, direct credit substitute, or
asset- or mortgage-backed security that is rated investment grade,
multiply the amount of assets from which risk of credit loss is
directly or indirectly retained or assumed by a risk weight of 50
percent.
   (4) Participations. The risk-weighted asset amount for a
participation interest in a direct credit substitute is calculated
as follows:
   (i) Determine the risk-weighted asset amount for the direct
credit substitute as if the bank held all of the interests in the
participation.
   (ii) Multiply the risk-weighted asset amount determined under
section 3(d)(4)(i) of this appendix A by the percentage of the
bank's participation interest.
   (iii) If the bank is exposed to more than its pro rata share of
the risk of credit loss on the direct credit substitute (e.g., the
bank remains secondarily liable on participations held by others),
add to the amount computed under section 3(d)(4)(ii) of this
appendix A an amount computed as follows: multiply the amount of the
direct credit substitute by the percentage of the direct credit
substitute held by others and then multiply the result by the lesser
of the risk-weight appropriate for the holders of those interests or
the risk weight appropriate for the direct credit substitute.
   (5) Limitations on risk-based capital requirements. (i) Low-
level recourse. If the maximum contractual liability or exposure to
credit loss retained or assumed by a bank in connection with a
recourse obligation or a direct credit substitute is less than the
effective risk-based capital requirement for the enhanced assets,
the risk-based capital requirement is limited to the maximum
contractual liability or exposure to loss, less any recourse
liability account established in accordance with generally accepted
accounting principles. This limitation does not apply to assets sold
with implicit recourse.
   (ii) Mortgage-related securities or participation certificates
retained in a mortgage loan swap. If a bank holds a mortgage-related
security or a participation certificate as a result of a mortgage
loan swap with recourse, capital is required to support the recourse
obligation plus the percentage of the mortgage-related security or
participation certificate that is not protected against risk of loss
by the recourse obligation. The total amount of capital required for
the on-balance sheet asset and the recourse obligation, however, is
limited to the capital requirement for the underlying loans,
calculated as if the bank continued to hold these loans as an on-
balance sheet asset.
   (iii) Related on-balance sheet assets. To the extent that an
asset is included in the calculation of the risk-based capital
requirement under this section 3(d) of this appendix A and may also
be included as an on-balance sheet asset, the asset is risk-weighted
only under this section 3(d) of this appendix A except that mortgage
servicing assets and similar arrangements with embedded recourse
obligations or direct credit substitutes are risk-weighted as on-
balance sheet assets and related recourse obligations and direct
credit substitutes are risk-weighted under this section 3(d) of this
appendix A.
* * * * *
   3. In appendix A, Table 2, item 1 under ``100 Percent Conversion
Factor'' is revised to read as follows:
* * * * *

Table 2--Credit Conversion Factors For Off-Balance Sheet Items

100 Percent Conversion Factor

   1. [Reserved]
* * * * *
   Dated: October 22, 1997.
Eugene A. Ludwig,
Comptroller of the Currency.

Federal Reserve System

12 CFR Chapter II

   For the reasons set forth in the joint preamble, parts 208 and 225
of chapter II of title 12 of the Code of Federal Regulations are
proposed to be amended as follows:

PART 208--MEMBERSHIP OF STATE BANKING INSTITUTIONS IN THE FEDERAL
RESERVE SYSTEM (REGULATION H)

   1. The authority citation for part 208 continues to read as
follows:

   Authority: 12 U.S.C. 24, 36, 92a, 93a, 248(a), 248(c), 321-338a,
371d, 461, 481-486, 601, 611, 1814, 1816, 1818, 1820(d)(9), 1823(j),
1828(o), 1831o, 1831p-1,1831 r-1, 1835a, 1882, 2901-2907, 3105,
3310, 3331-3351, and 3906-3909; 15 U.S.C. 78b, 78l(b), 78l(g),
78l(i), 78o-4(c)(5), 78q, 78q-1, and 78w; 31 U.S.C. 5318; 42 U.S.C.
4012a, 4104a, 4104b, 4106, and 4128.

   2. In appendix A to part 208, section III.B. is amended by revising
paragraph 3. and in paragraph 4., footnote 24 is redesignated as
footnote 28. The revision reads as follows:

Appendix A to Part 208--Capital Adequacy Guidelines for State Member
Banks: Risk-Based Measure

* * * * *
   III. * * *
   B. * * *
   3. Recourse obligations, direct credit substitutes, and asset -
and mortgage-backed securities. Direct credit substitutes, assets
transferred with recourse, and securities issued in connection with
asset securitizations are treated as described below.
   (a) Definitions-- (1) Direct credit substitute means an
arrangement in which a bank assumes, in form or in substance, any
risk of credit loss directly or indirectly associated with a third-
party asset or other financial claim, that exceeds the bank's pro
rata share of the asset or claim. If the bank has no claim on the
asset, then the assumption of any risk of loss is a direct credit
substitute. Direct credit substitutes include, but are not limited
to:
   (i) Financial guarantee-type standby letters of credit that
support financial claims on the account party;
   (ii) Guarantees, surety arrangements, and irrevocable guarantee-
type instruments backing financial claims such as outstanding
securities, loans, or other financial liabilities, or that back off-
balance-sheet items against which risk-based capital must be
maintained;
   (iii) Purchased subordinated interests or securities that absorb
more than their pro rata share of losses from the underlying assets;
   (iv) Loans or lines of credit that provide credit enhancement
for the financial obligations of an account party; and
   (v) Purchased loan servicing assets if the servicer is
responsible for credit losses associated with the loans being
serviced (other than mortgage servicer cash advances as defined in
paragraph III.B.3.(a)(3) of this appendix A), or if the servicer
makes or assumes representations and warranties on the loans other
than standard representations and warranties as defined in paragraph
III.B.3.(a)(6) of this appendix A.
   (2) Financial guarantee-type standby letter of credit means any
letter of credit or similar arrangement, however named or described,
that represents an irrevocable obligation to the beneficiary on the
part of the issuer:
   (i) To repay money borrowed by, advanced to, or for the account
of, the account party; or
   (ii) To make payment on account of any indebtedness undertaken
by the account party in the event that the account party fails to
fulfill its obligation to the beneficiary.
   (3) Mortgage servicer cash advance means funds that a
residential mortgage loan servicer advances to ensure an
uninterrupted flow of payments or the timely collection of
residential mortgage loans, including disbursements made to cover
foreclosure costs or other expenses arising from a mortgage loan to
facilitate its timely collection. A servicer cash advance is not a
recourse obligation or a direct credit substitute if the mortgage
servicer is entitled to full reimbursement or, for any one
residential mortgage loan, nonreimbursable

[[Page 59965]]

advances are contractually limited to an insignificant amount of the
outstanding principal on that loan.
   (4) Rated means, with respect to an instrument or obligation,
that the instrument or obligation has received a credit rating from
a nationally-recognized statistical rating organization. An
instrument or obligation is rated investment grade if it has
received a credit rating that falls within one of the four highest
rating categories used by the organization, e.g., at least BBB or
its equivalent. An instrument or obligation is rated in the highest
investment grade if it has received a credit rating that falls
within the highest rating category used by the organization.
   (5) Recourse means an arrangement in which a bank retains, in
form or in substance, any risk of credit loss directly or indirectly
associated with a transferred asset that exceeds a pro rata share of
the bank's claim on the asset. If a bank has no claim on a
transferred asset, then the retention of any risk of loss is
recourse. A recourse obligation typically arises when an institution
transfers assets and retains an obligation to repurchase the assets
or absorb losses due to a default of principal or interest or any
other deficiency in the performance of the underlying obligor or
some other party. Recourse may exist implicitly where a bank
provides credit enhancement beyond any contractual obligation to
support assets it has sold. Recourse obligations include, but are
not limited to:
   (i) Representations and warranties on the transferred assets
other than standard representations and warranties as defined in
paragraph III.B.3.(a)(6) of this appendix A;
   (ii) Retained loan servicing assets if the servicer is
responsible for losses associated with the loans being serviced
other than mortgage servicer cash advances as defined in paragraph
III.B.3.(a)(3) of this appendix A;
   (iii) Retained subordinated interests or securities that absorb
more than their pro rata share of losses from the underlying assets;
   (iv) Assets sold under an agreement to repurchase; and
   (v) Loan strips sold without direct recourse where the maturity
of the transferred loan that is drawn is shorter than the maturity
of the commitment.
   (6) Standard representations and warranties means contractual
provisions that a bank extends when it transfers assets (including
loan servicing assets) or assumes when it purchases loan servicing
assets. To qualify as a standard representation or warranty, a
contractual provision must:
   (i) Refer to facts that the seller or servicer can verify, and
has verified with reasonable due diligence, prior to the time that
assets are transferred (or servicing assets are acquired);
   (ii) Refer to a condition that is within the control of the
seller or servicer; or
   (iii) Provide for the return of assets in the event of fraud or
documentation deficiencies.
   (7) Traded position means a recourse obligation, direct credit
substitute, or asset- or mortgage-backed security that is retained,
assumed, or issued in connection with an asset securitization and
that is rated with a reasonable expectation that, in the near
future:
   (i) The position would be sold to investors relying on the
rating; or
   (ii) A third party would, in reliance on the rating, enter into
a transaction such as a purchase, loan, or repurchase agreement
involving the position.
   (b) Amount of position to be included in risk-weighted assets--
(1) Determining the credit equivalent amount of recourse obligations
and direct credit substitutes. The credit equivalent amount for a
recourse obligation or direct credit substitute (except as otherwise
provided in paragraph III.B.3.(b)(2) of this appendix A) is the full
amount of the credit enhanced assets from which risk of credit loss
is directly or indirectly retained or assumed. This credit
equivalent amount is assigned to the risk weight appropriate to the
obligor, or if relevant, the guarantor or nature of any collateral.
Thus, a bank that extends a partial direct credit substitute, e.g.,
a standby letter of credit that absorbs the first 10 percent of loss
on a transaction, must maintain capital against the full amount of
the assets being supported. Furthermore, for direct credit
substitutes that are on-balance sheet, e.g., purchased subordinated
securities, banks must maintain capital against the amount of the
direct credit substitutes and the full amounts of the assets being
supported, i.e., all more senior positions. This treatment is
subject to the low-level recourse rule discussed in section
III.B.3.(c)(1) of this appendix A. For purposes of this appendix A,
the full amount of the credit enhanced assets from which risk of
credit loss is directly or indirectly retained or assumed means for:
   (i) A financial guarantee-type standby letter of credit, surety
arrangement, guarantee, or irrevocable guarantee-type instruments,
the full amount of the assets that the direct credit substitute
fully or partially supports;
   (ii) A subordinated interest or security, the amount of the
subordinated interest or security plus all more senior interests or
securities;
   (iii) Mortgage servicing assets that are recourse obligations or
direct credit substitutes, the outstanding amount of the loans
serviced;
   (iv) Representations and warranties (other than standard
representations and warranties), the amount of the assets subject to
the representations or warranties;
   (v) Loans or lines of credit that provide credit enhancement for
the financial obligations of an account party, the full amount of
the enhanced financial obligations;
   (vi) Loans strips, the amount of the loans;
   (vii) For assets sold with recourse, the amount of assets from
which risk of loss is directly or indirectly retained, less any
applicable recourse liability account established in accordance with
generally accepted accounting principles; and
   (viii) Other types of recourse obligations or direct credit
substitutes should be treated in accordance with the principles
contained in section III.B.3. of this appendix A.
   (2) Determining the credit risk weight of investment grade
recourse obligations, direct credit substitutes, and asset- and
mortgage-backed securities. A traded position is eligible for the
risk-based capital treatment described in this paragraph if it has
been rated at least investment grade by a nationally-recognized
statistical rating organization. A recourse obligation or direct
credit substitute that is not a traded position is eligible for the
treatment described in this paragraph if it has been rated at least
investment grade by two nationally-recognized statistical rating
organizations, the ratings are publicly available, the ratings are
based on the same criteria used to rate securities sold to the
public, and the recourse obligation or direct credit substitute
provides credit enhancement to a securitization in which at least
one position is traded.
   (i) Highest investment grade. Except as otherwise provided in
this section III. of this appendix A, the face amount of a recourse
obligation, direct credit substitute, or an asset- or mortgage-
backed security that is rated in the highest investment grade
category is assigned to the 20 percent risk category.
   (ii) Other investment grade. [Option 1--Face Value Treatment]
Except as otherwise provided in this section III. of this appendix
A, the face amount of a recourse obligation, direct credit
substitute, or an asset- or mortgage-backed security that is rated
investment grade is assigned to the 100 percent risk category.
   [Option 2--Modified Gross-Up] Except as otherwise provided in
this section III. of this appendix A, for a recourse obligation,
direct credit substitute, or an asset- or mortgage-backed security
that is rated investment grade, the full amount of the credit
enhanced assets from which risk of credit loss is directly or
indirectly retained or assumed by the bank is assigned to the 50
percent risk category, regardless of the face amount of the bank's
risk position.
   (3) Risk participations and syndications in direct credit
substitutes--(i) In the case of direct credit substitutes in which a
risk participation 23 has been conveyed, the full amount
of the assets that are supported, in whole or in part, by the credit
enhancement are converted to a credit equivalent amount at 100
percent. However, the pro rata share of the credit equivalent amount
that has been conveyed through a risk participation is assigned to
whichever risk category is lower: the risk category appropriate to
the obligor, after considering any relevant guarantees or
collateral, or the risk category appropriate to the institution
acquiring the participation.24 Any remainder is assigned
to the risk category appropriate to the obligor, guarantor, or
collateral. For example, the pro rata share of the full amount of
the assets supported, in whole or in part, by a direct credit
substitute conveyed as a risk participation to a U.S. domestic
depository

[[Page 59966]]

institution or foreign bank is assigned to the 20 percent risk
category.25
---------------------------------------------------------------------------

   \23\ That is, a participation in which the originating bank
remains liable to the beneficiary for the full amount of the direct
credit substitute if the party that has acquired the participation
fails to pay when the instrument is drawn.
   \24\ A risk participation in bankers acceptances conveyed to
other institutions is also assigned to the risk category appropriate
to the institution acquiring the participation or, if relevant, the
guarantor or nature of the collateral.
   \25\ Risk participations with a remaining maturity of over one
year that are conveyed to non-OECD banks are to be assigned to the
100 percent risk category, unless a lower risk category is
appropriate to the obligor, guarantor, or collateral.
---------------------------------------------------------------------------

   (ii) The capital treatment for risk participations, either
conveyed or acquired, and syndications in direct credit substitutes
that are associated with an asset securitization and are rated at
least investment grade is set forth in paragraph III.B.3.(b)(2) of
this appendix A. A lower risk category may be applicable depending
upon the obligor or nature of the institution acquiring the
participation.
   (iii) In the case of direct credit substitutes in which a risk
participation has been acquired, the acquiring bank's percentage
share of the direct credit substitute is multiplied by the full
amount of the assets that are supported, in whole or in part, by the
credit enhancement and converted to a credit equivalent amount at
100 percent. The credit equivalent amount of an acquisition of a
risk participation in a direct credit substitute is assigned to the
risk category appropriate to the account party obligor or, if
relevant, the nature of the collateral or guarantees.
   (iv) In the case of direct credit substitutes that take the form
of a syndication where each bank is obligated only for its pro rata
share of the risk and there is no recourse to the originating bank,
each bank will only include its pro rata share of the assets
supported, in whole or in part, by the direct credit substitute in
its risk-based capital calculation.26
---------------------------------------------------------------------------

   \26\ For example, if a bank has a 10 percent share of a $10
syndicated direct credit substitute that provides credit support to
a $100 loan, then the bank's $1 pro rata share in the enhancement
means that a $10 pro rata share of the loan is included in risk
weighted assets.
---------------------------------------------------------------------------

   (c) Limitations on risk-based capital requirements--(1) Low-
level recourse. If the maximum contractual liability or exposure to
loss retained or assumed by a bank in connection with a recourse
obligation or a direct credit substitute is less than the effective
risk-based capital requirement for the enhanced assets, the risk-
based capital requirement is limited to the maximum contractual
liability or exposure to loss, less any recourse liability account
established in accordance with generally accepted accounting
principles. This limitation does not apply to assets sold with
implicit recourse.
   (2) Mortgage-related securities or participation certificates
retained in a mortgage loan swap. If a bank holds a mortgage-related
security or a participation certificate as a result of a mortgage
loan swap with recourse, capital is required to support the recourse
obligation plus the percentage of the mortgage-related security or
participation certificate that is not covered by the recourse
obligation. The total amount of capital required for the on-balance
sheet asset and the recourse obligation, however, is limited to the
capital requirement for the underlying loans, calculated as if the
bank continued to hold these loans as an on-balance sheet asset.
   (3) Related on-balance sheet assets. If a recourse obligation or
direct credit substitute subject to this section III.B.3. of this
appendix A also appears as a balance sheet asset, the balance sheet
asset is not included in a bank's risk-weighted assets, except in
the case of mortgage servicing assets and similar arrangements with
embedded recourse obligations or direct credit substitutes. In such
cases, both the on-balance sheet assets and the related recourse
obligations and direct credit substitutes are incorporated into the
risk-based capital calculation.
   (d) Privately-issued mortgage-backed securities. Generally, a
privately-issued mortgage-backed security meeting certain criteria,
set forth in the accompanying footnote,27 is essentially
treated as an indirect holding of the underlying assets, and
assigned to the same risk category as the underlying assets, but in
no case to the zero percent risk category. However, any class of a
privately-issued mortgage-backed security whose structure does not
qualify it to be regarded as an indirect holding of the underlying
assets or that can absorb more than its pro rata share of loss
without the whole issue being in default (for example, a so-called
subordinated class) is treated in accordance with section
III.B.3.(b) of this appendix A. Furthermore, all stripped mortgage-
backed securities, including interest-only strips (IOs), principal-
only strips (POs), and similar instruments, are assigned to the 100
percent risk weight category, regardless of the issuer or guarantor.
---------------------------------------------------------------------------

   \27\ A privately-issued mortgage-backed security may be treated
as an indirect holding of the underlying assets provided that: (1)
The underlying assets are held by an independent trustee and the
trustee has a first priority, perfected security interest in the
underlying assets on behalf of the holders of the security; (2)
either the holder of the security has an undivided pro rata
ownership interest in the underlying mortgage assets or the trust or
single purpose entity (or conduit) that issues the security has no
liabilities unrelated to the issued securities; (3) the security is
structured such that the cash flow from the underlying assets in all
cases fully meets the cash flow requirements of the security without
undue reliance on any reinvestment income; and (4) there is no
material reinvestment risk associated with any funds awaiting
distribution to the holders of the security. In addition, if the
underlying assets of a mortgage-backed security are composed of more
than one type of assets, for example, U.S. Government-sponsored
agency securities and privately-issued pass-through securities that
qualify for the 50 percent risk category, the entire mortgage-backed
security is generally assigned to the category appropriate to the
highest risk-weighted asset underlying the issue. Thus, in this
example, the security would receive the 50 percent risk weight
appropriate to the privately-issued pass-through securities.
---------------------------------------------------------------------------

* * * * *
   3. In appendix A to part 208, sections III.C.1. through 3.,
footnotes 25 through 37 are redesignated as footnotes 29 through 41 and
newly redesignated footnote 39 and section III.C.4. are revised to read
as follows:
* * * * *
   III. * * *
   C. * * *
   3. * * * 39 * * *
---------------------------------------------------------------------------

   \39\ a. Loans that qualify as loans secured by one-to four-
family residential properties or multifamily residential properties
are listed in the instructions to the commercial bank call report.
In addition, for risk-based capital purposes, loans secured by one-
to four-family residential properties include loans to builders with
substantial project equity for the construction of one-to four-
family residences that have been presold under firm contracts to
purchasers who have obtained firm commitments for permanent
qualifying mortgage loans and have made substantial earnest-money
deposits. b. The instructions to the call report also discuss the
treatment of loans, including multifamily housing loans, that are
sold subject to a pro rata loss-sharing arrangement. Such an
arrangement should be treated by the selling bank as sold to the
extent that the sales agreement provides for the purchaser of the
loan to share in any loss incurred on the loan on a pro rata basis
with the selling bank. In such a transaction, from the stand-point
of the selling bank, the portion of the loan that is treated as sold
is not subject to the risk-based capital standards. In connection
with sales of multifamily housing loans in which the purchaser of a
loan shares in any loss incurred on the loan with the selling
institution on other than a pro rata basis, the selling bank must
treat these other loss-sharing arrangements in accordance with
section III.B.3. of this appendix A.
---------------------------------------------------------------------------

* * * * *
   4. Category 4: 100 percent. (a) All assets not included in the
categories above are assigned to this category, which comprises
standard risk assets. The bulk of the assets typically found in a
loan portfolio would be assigned to the 100 percent category.
   (b) This category includes long-term claims on, and the portions
of long-term claims that are guaranteed by, non-OECD banks, and all
claims on non-OECD central governments that entail some degree of
transfer risk.42 This category includes all claims on
foreign and domestic private-sector obligors not included in the
categories above (including loans to nondepository financial
institutions and bank holding companies); claims on commercial firms
owned by the public sector; customer liabilities to the bank on
acceptances outstanding involving standard risk claims;43
investments in fixed assets, premises, and other real estate owned;
common and preferred stock of corporations, including stock acquired
for debts previously contracted; commercial and consumer loans
(except those assigned to lower risk categories due to recognized
guarantees or collateral and loans secured by residential property
that qualify for a lower risk weight); and all stripped mortgage-
backed securities and similar instruments.
---------------------------------------------------------------------------

   \42\ Such assets include all nonlocal-currency claims on, and
the portions of claims that are guaranteed by, non-OECD central
governments and those portions of local-currency claims on, or
guaranteed by, non-OECD central governments that exceed the local-
currency liabilities held by subsidiary depository institutions.
   \43\ Customer liabilities on acceptances outstanding involving
nonstandard risk claims, such as claims on U.S. depository
institutions, are assigned to the risk category appropriate to the
identity of the obligor or, if relevant, the nature of the
collateral or guarantees backing the claims. Portions of acceptances
conveyed as risk participations to U.S. depository institutions or
foreign banks are assigned to the 20 percent risk category
appropriate to short-term claims guaranteed by U.S. depository
institutions and foreign banks.
---------------------------------------------------------------------------

   (c) Also included in this category are industrial-development
bonds and similar obligations issued under the auspices of state or
political subdivisions of the OECD-based

[[Page 59967]]

group of countries for the benefit of a private party or enterprise
where that party or enterprise, not the government entity, is
obligated to pay the principal and interest, and all obligations of
states or political subdivisions of countries that do not belong to
the OECD-based group.
   (d) The following assets also are assigned a risk weight of 100
percent if they have not been deducted from capital: investments in
unconsolidated companies, joint ventures, or associated companies;
instruments that qualify as capital issued by other banking
organizations; and any intangibles, including those that may have
been grandfathered into capital.
* * * * *
   4. In appendix A to part 208, the introductory paragraph in section
III.D. and section III.D.1. are revised to read as follows:
* * * * *
   III. * * *
   D. Off-Balance Sheet Items
   The face amount of an off-balance sheet item is generally
incorporated into risk-weighted assets in two steps. The face amount
is first multiplied by a credit conversion factor, except for direct
credit substitutes and recourse obligations as discussed in section
III.D.1. of this appendix A. The resultant credit equivalent amount
is assigned to the appropriate risk category according to the
obligor or, if relevant, the guarantor or the nature of the
collateral.44 Attachment IV to this appendix A sets forth
the conversion factors for various types of off-balance-sheet items.
---------------------------------------------------------------------------

   \44\ The sufficiency of collateral and guarantees for off-
balance-sheet items is determined by the market value of the
collateral of the amount of the guarantee in relation to the face
amount of the item, except for derivative contracts, for which this
determination is generally made in relation to the credit equivalent
amount. Collateral and guarantees are subject to the same provisions
noted under section III.B. of this appendix A.
---------------------------------------------------------------------------

   1. Items with a 100 percent conversion factor. (a) Except as
otherwise provided in section III.B.3. of this appendix A, the full
amount of an asset or transaction supported, in whole or in part, by
a direct credit substitute or a recourse obligation. Direct credit
substitutes and recourse obligations are defined in section III.B.3.
of this appendix A.
   (b) Sale and repurchase agreements, if not already included on
the balance sheet, and forward agreements. Forward agreements are
legally binding contractual obligations to purchase assets with
certain drawdown at a specified future date. Such obligations
include forward purchases, forward deposits
placed,45 and partly-paid shares and securities; they do
not include commitments to make residential mortgage loans or
forward foreign exchange contracts.
---------------------------------------------------------------------------

   \45\ Forward deposits accepted are treated as interest
rate contracts.
---------------------------------------------------------------------------

   (c) Securities lent by a bank are treated in one of two ways,
depending upon whether the lender is at risk of loss. If a bank, as
agent for a customer, lends the customer's securities and does not
indemnify the customer against loss, then the transaction is
excluded from the risk-based capital calculation. If, alternatively,
a bank lends its own securities or, acting as agent for a customer,
lends the customer's securities and indemnifies the customer against
loss, the transaction is converted at 100 percent and assigned to
the risk weight category appropriate to the obligor or, if
applicable to any collateral delivered to the lending bank the
independent custodian acting on the lending bank's behalf. Where a
bank is acting as agent for a customer in a transaction involving
the lending or sale of securities that is collateralized by cash
delivered to the bank, the transaction is deemed to be
collateralized by cash on deposit in the bank for purposes of
determining the appropriate risk-weight category, provided that any
indemnification is limited to no more than the difference between
the market value of the securities and the cash collateral received
and any reinvestment risk associated with that cash collateral is
borne by the customer.
* * * * *

PART 225--BANK HOLDING COMPANIES AND CHANGE IN BANK CONTROL
(REGULATION Y)

   1. The authority citation for part 225 continues to read as
follows:

   Authority: 12 U.S.C. 1817(j)(13), 1818, 1828(o), 1831i, 1831p-1,
1843(c)(8), 1844(b), 1972(1), 3106, 3108, 3310, 3331-3351, 3907, and
3909.

   2. In appendix A to part 225, section III.B. is amended by revising
paragraph 3. and in paragraph 4., footnote 27 is redesignated as
footnote 31. The revision reads as follows:

Appendix A to Part 225--Capital Adequacy Guidelines for Bank
Holding Companies: Risk-Based Measure

* * * * *
   III. * * *
   B.* * *
   3. Recourse obligations, direct credit substitutes, and asset-
and mortgage-backed securities. Direct credit substitutes, assets
transferred with recourse, and securities issued in connection with
asset securitizations are treated as described below.
   (a) Definitions--(1) Direct credit substitute means an
arrangement in which a banking organization assumes, in form or in
substance, any risk of credit loss directly or indirectly associated
with a third-party asset or other financial claim, that exceeds the
banking organization's pro rata share of the asset or claim. If the
banking organization has no claim on the asset, then the assumption
of any risk of loss is a direct credit substitute. Direct credit
substitutes include, but are not limited to:
   (i) Financial guarantee-type standby letters of credit that
support financial claims on the account party;
   (ii) Guarantees, surety arrangements, and irrevocable guarantee-
type instruments backing financial claims such as outstanding
securities, loans, or other financial liabilities, or that back off-
balance-sheet items against which risk-based capital must be
maintained;
   (iii) Purchased subordinated interests or securities that absorb
more than their pro rata share of losses from the underlying assets;
   (iv) Loans or lines of credit that provide credit enhancement
for the financial obligations of an account party; and
   (v) Purchased loan servicing assets if the servicer is
responsible for credit losses associated with the loans being
serviced (other than mortgage servicer cash advances as defined in
paragraph III.B.3.(a)(3) of this appendix A), or if the servicer
makes or assumes representations and warranties on the loans other
than standard representations and warranties as defined in paragraph
III.B.3.(a)(6) of this appendix A.
   (2) Financial guarantee-type standby letter of credit means any
letter of credit or similar arrangement, however named or described,
that represents an irrevocable obligation to the beneficiary on the
part of the issuer:
   (i) To repay money borrowed by, advanced to, or for the account
of, the account party; or
   (ii) To make payment on account of any indebtedness undertaken
by the account party in the event that the account party fails to
fulfill its obligation to the beneficiary.
   (3) Mortgage servicer cash advance means funds that a
residential mortgage loan servicer advances to ensure an
uninterrupted flow of payments or the timely collection of
residential mortgage loans, including disbursements made to cover
foreclosure costs or other expenses arising from a mortgage loan to
facilitate its timely collection. A servicer cash advance is not a
recourse obligation or a direct credit substitute if the mortgage
servicer is entitled to full reimbursement or, for any one
residential mortgage loan, nonreimbursable advances are
contractually limited to an insignificant advances of the
outstanding principal on that loan.
   (4) Rated means, with respect to an instrument or obligation,
that the instrument or obligation has received a credit rating from
a nationally-recognized statistical rating organization. An
instrument or obligation is rated investment grade if it has
received a credit rating that falls within one of the four highest
rating categories used by the organization. An instrument or
obligation is rated in the highest investment grade if it has
received a credit rating that falls within the highest rating
category used by the organization.
   (5) Recourse means an arrangement in which a banking
organization retains, in form or in substance, any risk of credit
loss directly or indirectly associated with a transferred asset that
exceeds a pro rata share of the banking organization's claim on the
asset. If a banking organization has no claim on a transferred
asset, then the retention of any risk of loss is recourse. A
recourse obligation typically arises when an institution transfers
assets and retains an obligation to repurchase the assets or absorb
losses due to a default of principal or interest or any other
deficiency in the performance of the underlying obligor or some
other party. Recourse may exist implicitly where a banking
organization provides credit enhancement beyond any contractual

[[Page 59968]]

obligation to support assets it has sold. Recourse obligations
include, but are not limited to:
   (i) Representations and warranties on the transferred assets
other than standard representations and warranties as defined in
paragraph III.B.3.(a)(6) of this appendix A;
   (ii) Retained loan servicing assets if the servicer is
responsible for losses associated with the loans being serviced
other than mortgage servicer cash advances as defined in paragraph
III.B.3.(a)(3) of this appendix A;
   (iii) Retained subordinated interests or securities that absorb
more than their pro rata share of losses from the underlying assets;
   (iv) Assets sold under an agreement to repurchase; and
   (v) Loan strips sold without direct recourse where the maturity
of the transferred loan that is drawn is shorter than the maturity
of the commitment.
   (6) Standard representations and warranties means contractual
provisions that a banking organization extends when it transfers
assets (including loan servicing assets) or assumes when it
purchases loan servicing assets. To qualify as a standard
representation or warranty, a contractual provision must:
   (i) Refer to facts that the seller or servicer can verify, and
has verified with reasonable due diligence, prior to the time that
assets are transferred (or servicing assets are acquired);
   (ii) Refer to a condition that is within the control of the
seller or servicer; or
   (iii) Provide for the return of assets in the event of fraud or
documentation deficiencies.
   (7) Traded position means a recourse obligation, direct credit
substitute, or asset- or mortgage-backed security that is retained,
assumed, or issued in connection with an asset securitization and
that is rated with a reasonable expectation that, in the near
future:
   (i) The position would be sold to investors relying on the
rating; or
   (ii) A third party would, in reliance on the rating, enter into
a transaction such as a purchase, loan, or repurchase agreement
involving the position.
   (b) Amount of position to be included in risk-weighted assets--
(1) Determining the credit equivalent amount of recourse obligations
and direct credit substitutes. The credit equivalent amount for a
recourse obligation or direct credit substitute (except as otherwise
provided in paragraph III.B.3.(b)(2) of this appendix A) is the full
amount of the credit enhanced assets from which risk of credit loss
is directly or indirectly retained or assumed. This credit
equivalent amount is assigned to the risk weight appropriate to the
obligor, or if relevant, the guarantor or nature of any collateral.
Thus, a banking organization that extends a partial direct credit
substitute, e.g., a standby letter of credit that absorbs the first
10 percent of loss on a transaction, must maintain capital against
the full amount of the assets being supported. Furthermore, for
direct credit substitutes that are on-balance sheet, e.g., purchased
subordinated securities, banking organizations must maintain capital
against the amount of the direct credit substitutes and the full
amounts of the assets being supported, i.e., all more senior
positions. This treatment is subject to the low-level recourse rule
discussed in paragraph III.B.3.(c)(1) of this appendix A. For
purposes of this appendix A, the full amount of the credit enhanced
assets from which risk of credit loss is directly or indirectly
retained or assumed means for:
   (i) A financial guarantee-type standby letter of credit, surety
arrangement, guarantee, or irrevocable guarantee-type instruments,
the full amount of the assets that the direct credit substitute
fully or partially supports;
   (ii) A subordinated interest or security, the amount of the
subordinated interest or security plus all more senior interests or
securities;
   (iii) Mortgage servicing assets that are recourse obligations or
direct credit substitutes, the outstanding amount of the loans
serviced;
   (iv) Representations and warranties (other than standard
representations and warranties), the amount of the assets subject to
the representations or warranties;
   (v) Loans or lines of credit that provide credit enhancement for
the financial obligations of an account party, the full amount of
the enhanced financial obligations;
   (vi) Loans strips, the amount of the loans;
   (vii) For assets sold with recourse, the amount of assets from
which risk of loss is directly or indirectly retained, less any
applicable recourse liability account established in accordance with
generally accepted accounting principles; and
   (viii) Other types of recourse obligations or direct credit
substitutes should be treated in accordance with the principles
contained in paragraph III.B.3.(b)(3) of this appendix A.
   (2) Determining the credit risk weight of investment grade
recourse obligations, direct credit substitutes, and asset- and
mortgage-backed securities. A traded position is eligible for the
risk-based capital treatment described in this paragraph if it has
been rated at least investment grade by a nationally-recognized
statistical rating organization. A recourse obligation or direct
credit substitute that is not a traded position is eligible for the
treatment described in this paragraph if it has been rated at least
investment grade by two nationally-recognized statistical rating
organizations, the ratings are publicly available, the ratings are
based on the same criteria used to rate securities sold to the
public, and the recourse obligation or direct credit substitute
provides credit enhancement to a securitization in which at least
one position is traded.
   (i) Highest investment grade. Except as otherwise provided in
section III. of this appendix A, the face amount of a recourse
obligation, direct credit substitute, or an asset- or mortgage-
backed security that is rated in the highest investment grade
category is assigned to the 20 percent risk category.
   (ii) Other investment grade. [Option 1--Face Value Treatment]
Except as otherwise provided in this section III. of this appendix
A, the face amount of a recourse obligation, direct credit
substitute, or an asset- or mortgage-backed security that is rated
investment grade is assigned to the 100 percent risk category.
   [Option 2--Modified Gross-Up] Except as otherwise provided in
section III. of this appendix A, for a recourse obligation, direct
credit substitute, or an asset or mortgage-backed security that is
rated investment grade, the full amount of the credit enhanced
assets from which risk of credit loss is directly or indirectly
retained or assumed by the banking organization is assigned to the
50 percent risk category, regardless of the face amount of the
banking organization's risk position.
   (3) Risk participations and syndications in direct credit
substitutes--(i) In the case of direct credit substitutes in which a
risk participation 26 has been conveyed, the full amount
of the assets that are supported, in whole or in part, by the credit
enhancement are converted to a credit equivalent amount at 100
percent. However, the pro rata share of the credit equivalent amount
that has been conveyed through a risk participation is assigned to
whichever risk category is lower: the risk category appropriate to
the obligor, after considering any relevant guarantees or
collateral, or the risk category appropriate to the institution
acquiring the participation.27 Any remainder is assigned
to the risk category appropriate to the obligor, guarantor, or
collateral. For example, the pro rata share of the full amount of
the assets supported, in whole or in part, by a direct credit
substitute conveyed as a risk participation to a U.S. domestic
depository institution or foreign bank is assigned to the 20 percent
risk category.28
---------------------------------------------------------------------------

   \26\ That is, a participation in which the originating banking
organization remains liable to the beneficiary for the full amount
of the direct credit substitute if the party that has acquired the
participation fails to pay when the instrument is drawn.
   \27\ A risk participation in bankers acceptances conveyed to
other institutions is also assigned to the risk category appropriate
to the institution acquiring the participation or, if relevant, the
guarantor or nature of the collateral.
   \28\ Risk participations with a remaining maturity of over one
year that are conveyed to non-OECD banks are to be assigned to the
100 percent risk category, unless a lower risk category is
appropriate to the obligor, guarantor, or collateral.
---------------------------------------------------------------------------

   (ii) The capital treatment for risk participations, either
conveyed or acquired, and syndications in direct credit substitutes
that are associated with an asset securitization and are rated at
least investment grade is set forth in paragraph III.B.3.(b)(2) of
this appendix A. A lower risk category may be applicable depending
upon the obligor or nature of the institution acquiring the
participation.
   (iii) In the case of direct credit substitutes in which a risk
participation has been acquired, the acquiring banking
organization's percentage share of the direct credit substitute is
multiplied by the full amount of the assets that are supported, in
whole or in part, by the credit enhancement and converted to a
credit equivalent amount at 100 percent. The credit equivalent
amount of an acquisition of a risk participation in a direct credit
substitute is assigned to the risk category appropriate to the
account party obligor or, if relevant, the nature of the collateral
or guarantees.

[[Page 59969]]

   (iv) In the case of direct credit substitutes that take the form
of a syndication where each banking organization is obligated only
for its pro rata share of the risk and there is no recourse to the
originating banking organization, each banking organization will
only include its pro rata share of the assets supported, in whole or
in part, by the direct credit substitute in its risk-based capital
calculation.29
---------------------------------------------------------------------------

   \29\ For example, if a banking organization has a 10 percent
share of a $10 syndicated direct credit substitute that provides
credit support to a $100 loan, then the banking organization $1 pro
rata share in the enhancement means that a $10 pro rata share of the
loan is included in risk-weighted assets.
---------------------------------------------------------------------------

   (c) Limitations on risk-based capital requirements--(1) Low-
level recourse. If the maximum contractual liability or exposure to
loss retained or assumed by a banking organization in connection
with a recourse obligation or a direct credit substitute is less
than the effective risk-based capital requirement for the enhanced
assets, the risk-based capital requirement is limited to the maximum
contractual liability or exposure to loss, less any recourse
liability account established in accordance with generally accepted
accounting principles. This limitation does not apply to assets sold
with implicit recourse.
   (2) Mortgage-related securities or participation certificates
retained in a mortgage loan swap. If a banking organization holds a
mortgage-related security or a participation certificate as a result
of a mortgage loan swap with recourse, capital is required to
support the recourse obligation plus the percentage of the mortgage-
related security or participation certificate that is not covered by
the recourse obligation. The total amount of capital required for
the on-balance sheet asset and the recourse obligation, however, is
limited to the capital requirement for the underlying loans,
calculated as if the banking organization continued to hold these
loans as an on-balance sheet asset.
   (3) Related on-balance sheet assets. If a recourse obligation or
direct credit substitute subject to section III.B.3. of this
appendix A also appears as a balance sheet asset, the balance sheet
asset is not included in a banking organization's risk-weighted
assets, except in the case of mortgage servicing assets and similar
arrangements with embedded recourse obligations or direct credit
substitutes. In such cases, both the on-balance sheet assets and the
related recourse obligations and direct credit substitutes are
incorporated into the risk-based capital calculation.
   (d) Privately-issued mortgage-backed securities. Generally, a
privately-issued mortgage-backed security meeting certain criteria,
set forth in the accompanying footnote,30 is essentially
treated as an indirect holding of the underlying assets, and
assigned to the same risk category as the underlying assets, but in
no case to the zero percent risk category. However, any class of a
privately-issued mortgage-backed security whose structure does not
qualify it to be regarded as an indirect holding of the underlying
assets or that can absorb more than its pro rata share of loss
without the whole issue being in default (for example, a so-called
subordinated class) is treated in accordance with section
III.B.3.(b) of this appendix A. Furthermore, all stripped mortgage-
backed securities, including (IOs), principal-only strips (POs), and
similar instruments, are assigned to the 100 percent risk weight
category, regardless of the issuer or guarantor.
---------------------------------------------------------------------------

   \30\ A privately-issued mortgage-backed security may be treated
as an indirect holding of the underlying assets provided that: (1)
the underlying assets are held by an independent trustee and the
trustee has a first priority, perfected security interest in the
underlying assets on behalf of the holders of the security; (2)
either the holder of the security has an undivided pro rata
ownership interest in the underlying mortgage assets or the trust or
single purpose entity (or conduit) that issues the security has no
liabilities unrelated to the issued securities; (3) the security is
structured such that the cash flow from the underlying assets in all
cases fully meets the cash flow requirements of the security without
undue reliance on any reinvestment income; and (4) there is no
material reinvestment risk associated with any funds awaiting
distribution to the holders of the security. In addition, if the
underlying assets of a mortgage-backed security are composed of more
than one type of assets, for example, U.S. Government-sponsored
agency securities and privately-issued pass-through securities that
qualify for the 50 percent risk category, the entire mortgage-backed
security is generally assigned to the category appropriate to the
highest risk-weighted asset underlying the issue. Thus, in this
example, the security would receive the 50 percent risk weight
appropriate to the privately-issued pass-through securities.
---------------------------------------------------------------------------

* * * * *
   3. In appendix A to part 225, sections III.C.1. through 3.,
footnotes 28 through 40 are redesignated as footnotes 32 through 44 and
section III.C.4. is revised to read as follows:
* * * * *
   III. * * *
   C. * * *
   4. Category 4: 100 percent. (a) All assets not included in the
categories above are assigned to this category, which comprises
standard risk assets. The bulk of the assets typically found in a
loan portfolio would be assigned to the 100 percent category.
   (b) This category includes long-term claims on, and the portions
of long-term claims that are guaranteed by, non-OECD banks, and all
claims on non-OECD central governments that entail some degree of
transfer risk.45 This category includes all claims on
foreign and domestic private-sector obligors not included in the
categories above (including loans to nondepository financial
institutions and bank holding companies); claims on commercial firms
owned by the public sector; customer liabilities to the bank on
acceptances outstanding involving standard risk claims;
46 investments in fixed assets, premises, and other real
estate owned; common and preferred stock of corporations, including
stock acquired for debts previously contracted; commercial and
consumer loans (except those assigned to lower risk categories due
to recognized guarantees or collateral and loans secured by
residential property that qualify for a lower risk weight); and all
stripped mortgage-backed securities and similar instruments.
---------------------------------------------------------------------------

   \45\ Such assets include all nonlocal currency claims on, and
the portions of claims that are guaranteed by, non-OECD central
governments and those portions of local currency claims on, or
guaranteed by, non-OECD central governments that exceed the local
currency liabilities held by subsidiary depository institutions.
   \46\ Customer liabilities on acceptances outstanding involving
nonstandard risk claims, such as claims on U.S. depository
institutions, are assigned to the risk category appropriate to the
identity of the obligor or, if relevant, the nature of the
collateral or guarantees backing the claims. Portions of acceptances
conveyed as risk participations to U.S. depository institutions or
foreign banks are assigned to the 20 percent risk category
appropriate to short-term claims guaranteed by U.S. depository
institutions and foreign banks.
---------------------------------------------------------------------------

   (c) Also included in this category are industrial-development
bonds and similar obligations issued under the auspices of state or
political subdivisions of the OECD-based group of countries for the
benefit of a private party or enterprise where that party or
enterprise, not the government entity, is obligated to pay the
principal and interest, and all obligations of states or political
subdivisions of countries that do not belong to the OECD-based
group.
   (d) The following assets also are assigned a risk weight of 100
percent if they have not been deducted from capital: investments in
unconsolidated companies, joint ventures, or associated companies;
instruments that qualify as capital issued by other banking
organizations; and any intangibles, including those that may have
been grandfathered into capital.
* * * * *
   4. In appendix A to part 225, the introductory paragraph and
paragraph 1. in section III.D. are revised and footnote 49 is added and
reserved to read as follows:
* * * * *
   III. * * *
   D. Off-Balance Sheet Items
   The face amount of an off-balance sheet item is generally
incorporated into the risk-weighted assets in two steps. The face
amount is first multiplied by a credit conversion factor, except for
direct credit substitutes and recourse obligations as discussed in
paragraph III.D.1. of this appendix A. The resultant credit
equivalent amount is assigned to the appropriate risk category
according to the obligor or, if relevant, the guarantor or the
nature of the collateral.47 Attachment IV to this
appendix A sets forth the conversion factors for various types of
off-balance-sheet items.
---------------------------------------------------------------------------

   \47\ The sufficiency of collateral and guarantees for off-
balance-sheet items is determined by the market value of the
collateral of the amount of the guarantee in relation to the face
amount of the item, except for derivative contracts, for which this
determination is generally made in relation to the credit equivalent
amount. Collateral and guarantees are subject to the same provisions
noted under section III.B. of this appendix A.
---------------------------------------------------------------------------

   1. Items with a 100 percent conversion factor. (a) Except as
otherwise provided in paragraph III.B.3. of this appendix A, the
full amount of an asset or transaction supported, in whole or in
part, by a direct credit

[[Page 59970]]

substitute or a recourse obligation. Direct credit substitutes and
recourse obligations are defined in paragraph III.B.3. of this
appendix A.
   (b) Sale and repurchase agreements, if not already included on
the balance sheet, and forward agreements. Forward agreements are
legally binding contractual obligations to purchase assets with
certain drawdown at a specified future date. Such obligations
include forward purchases, forward deposits
placed,48 and partly-paid shares and securities; they do
not include commitments to make residential mortgage loans or
forward foreign exchange contracts.
---------------------------------------------------------------------------

   \48\ Forward deposits accepted are treated as interest
rate contracts.
---------------------------------------------------------------------------

   (c) Securities lent by a banking organization are treated in one
of two ways, depending upon whether the lender is at risk of loss.
If a banking organization, as agent for a customer, lends the
customer's securities and does not indemnify the customer against
loss, then the transaction is excluded from the risk-based capital
calculation. If, alternatively, a bank lends its own securities or,
acting as agent for a customer, lends the customer's securities and
indemnifies the customer against loss, the transaction is converted
at 100 percent and assigned to the risk weight category appropriate
to the obligor or, if applicable, to any collateral delivered to the
lending banking organization or the independent custodian acting on
the lending banking organization's behalf. Where a banking
organization is acting as agent for a customer in a transaction
involving the lending or sale of securities that is collateralized
by cash delivered to the banking organization, the transaction is
deemed to be collateralized by cash on deposit in the banking
organization for purposes of determining the appropriate risk-weight
category, provided that any indemnification is limited to no more
than the difference between the market value of the securities and
the cash collateral received and any reinvestment risk associated
with that cash collateral is borne by the customer.
* * * * *
   By order of the Board of Governors of the Federal Reserve
System, October 21, 1997.
William W. Wiles,
Secretary of the Board.

Federal Deposit Insurance Corporation

12 CFR CHAPTER III

Authority and Issuance

   For the reasons set forth in the joint preamble, part 325 of
chapter III of title 12 of the Code of Federal Regulations is proposed
to be amended as follows:

PART 325--CAPITAL MAINTENANCE

   1. The authority citation for part 325 continues to read as
follows:

   Authority: 12 U.S.C. 1815(a), 1815(b), 1816, 1818(a), 1818(b),
1818(c), 1818(t), 1819(Tenth), 1828(c), 1828(d), 1828(i), 1828(n),
1828(o), 1831o, 3907, 3909, 4808; Pub. L. 102-233, 105 Stat. 1761,
1789, 1790 (12 U.S.C. 1831n note); Pub. L. 102-242, 105 Stat. 2236,
2355, 2386 (12 U.S.C. 1828 note).

   2. In appendix A to part 325, section II.B. is amended by revising
paragraph 5. to read as follows:

Appendix A to Part 325--Statement of Policy on Risk-Based Capital

* * * * *

II. Procedures for Computing Risk-Weighted Assets

* * * * *
   B. * * *
   5. Recourse obligations, direct credit substitutes, and asset-
and mortgage-backed securities. Direct credit substitutes, assets
transferred with recourse, and securities issued in connection with
asset securitizations are treated as described in paragraphs B.5.(b)
through (e) of this section.
   (a) Definitions. (i) Direct credit substitute means an
arrangement in which a bank assumes, in form or in substance, any
risk of credit loss directly or indirectly associated with a third-
party asset or other financial claim, that exceeds the bank's pro
rata share of the asset or claim. If the bank has no claim on the
asset, then the assumption of any risk of loss is a direct credit
substitute. Direct credit substitutes include, but are not limited
to:
   (1) Financial guarantee-type standby letters of credit that
support financial claims on the account party;
   (2) Guarantees, surety arrangements, and irrevocable guarantee-
type instruments backing financial claims such as outstanding
securities, loans, or other financial liabilities, or that back off-
balance-sheet items against which risk-based capital must be
maintained;
   (3) Purchased subordinated interests or securities that absorb
more than their pro rata share of losses from the underlying assets;
   (4) Loans or lines of credit that provide credit enhancement for
the financial obligations of an account party; and
   (5) Purchased loan servicing assets if the servicer is
responsible for credit losses associated with the loans being
serviced (other than mortgage servicer cash advances as defined in
paragraph B.5.(a)(iii) of this section), or if the servicer makes or
assumes representations and warranties on the loans other than
standard representations and warranties as defined in paragraph
B.5.(a)(vii) of this section.
   (ii) Financial guarantee-type standby letter of credit means any
letter of credit or similar arrangement, however named or described,
that represents an irrevocable obligation to the beneficiary on the
part of the issuer:
   (1) To repay money borrowed by, advanced to, or for the account
of, the account party; or
   (2) To make payment on account of any indebtedness undertaken by
the account party in the event that the account party fails to
fulfill its obligation to the beneficiary.
   (iii) Mortgage servicer cash advance means funds that a
residential mortgage loan servicer advances to ensure an
uninterrupted flow of payments or the timely collection of
residential mortgage loans, including disbursements made to cover
foreclosure costs or other expenses arising from a mortgage loan to
facilitate its timely collection. A servicer cash advance is not a
recourse obligation or a direct credit substitute if the mortgage
servicer is entitled to full reimbursement or, for any one
residential mortgage loan, nonreimbursable advances are
contractually limited to an insignificant amount of the outstanding
principal on that loan.
   (iv) 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
Commission's uniform net capital requirements for brokers or dealers
(17 CFR 240.15c3-1(c)(2)(vi)(E), (F), and (H)).
   (v) Rated means a recourse obligation, direct credit substitute,
or asset-or mortgage-backed security that is retained, assumed, or
issued in connection with an asset securitization and that has
received a credit rating from a nationally recognized statistical
rating organization. A position is rated investment grade if it has
received a credit rating that falls within one of the four highest
rating categories used by the organization (e.g., at least ``BBB''
or its equivalent). A position is rated in the highest investment
grade if it has received a credit rating that falls within the
highest rating category used by the organization.
   (vi) Recourse means an arrangement in which a bank retains, in
form or in substance, any risk of credit loss directly or indirectly
associated with a transferred asset that exceeds a pro rata share of
the bank's claim on the asset. If a bank has no claim on a
transferred asset, then the retention of any risk of loss is
recourse. A recourse obligation typically arises when an institution
transfers assets and retains an obligation to repurchase the assets
or absorb losses due to a default of principal or interest or any
other deficiency in the performance of the underlying obligor or
some other party. Recourse may exist implicitly where a bank
provides credit enhancement beyond any contractual obligation to
support assets it has sold. Recourse obligations include, but are
not limited to:
   (1) Representations and warranties on the transferred assets
other than standard representations and warranties as defined in
paragraph B.5.(a)(vii) of this section;
   (2) Retained loan servicing assets if the servicer is
responsible for losses associated with the loans being serviced
other than mortgage servicer cash advances as defined in paragraph
B.5.(a)(iii) of this section;
   (3) Retained subordinated interests or securities that absorb
more than their pro rata share of losses from the underlying assets;
   (4) Assets sold under an agreement to repurchase; and
   (5) Loan strips sold without direct recourse where the maturity
of the transferred loan that is drawn is shorter than the maturity
of the commitment.
   (vii) Standard representations and warranties means contractual
assurances regarding the nature, quality, and condition of assets
that a bank extends when it transfers

[[Page 59971]]

assets (including loan servicing assets) or assumes when it
purchases loan servicing assets, but only to the extent that the
assurances:
   (1) Refer to facts that the seller or servicer can verify, and
has verified with reasonable due diligence, prior to the time that
assets are transferred (or servicing assets are acquired);
   (2) Refer to a condition that is within the control of the
seller or servicer; or
   (3) Provide for the return of assets in the event of fraud or
documentation deficiencies.
   (viii) Traded position means a recourse obligation, direct
credit substitute, or asset-or mortgage-backed security that is
retained, assumed, or issued in connection with an asset
securitization and that is rated with a reasonable expectation that,
in the near future:
   (1) The position would be sold to investors relying on the
rating; or
   (2) A third party would, in reliance on the rating, enter into a
transaction such as a purchase, loan, or repurchase agreement
involving the position.
   (b) Amount of position to be included in risk-weighted assets.
(i) General rule. The credit equivalent amount for a recourse
obligation or direct credit substitute is the full amount of the
credit enhanced assets from which risk of credit loss is directly or
indirectly retained or assumed. This credit equivalent amount is
assigned to the risk weight appropriate to the obligor or, if
relevant, the guarantor or nature of any collateral. For purposes of
this appendix A, the full amount of the credit enhanced assets from
which risk of credit loss is directly or indirectly retained or
assumed means for:
   (1) A financial guarantee-type standby letter of credit, surety
arrangement, guarantee, or irrevocable guarantee-type instruments,
the full amount of the assets that the direct credit substitute
fully or partially supports;
   (2) A subordinated interest or security, the amount of the
subordinated interest or security plus all more senior interests or
securities;
   (3) Mortgage servicing assets that are recourse obligations or
direct credit substitutes, the outstanding amount of the loans
serviced;
   (4) Representations and warranties (other than standard
representations and warranties), the amount of the assets subject to
the representations or warranties;
   (5) Loans or lines of credit that provide credit enhancement for
the financial obligations of an account party, the full amount of
the enhanced financial obligations;
   (6) Loans strips, the amount of the loans; and
   (7) For assets sold with recourse, the amount of assets from
which risk of loss is directly or indirectly retained, less any
applicable recourse liability account established in accordance with
generally accepted accounting principles.
   For example, a bank that extends a partial direct credit
substitute, e.g., a financial guarantee-type standby letter of
credit that absorbs the first 10 percent of loss on a transaction,
must maintain capital against the full amount of the assets being
supported. Furthermore, for a recourse obligation or a direct credit
substitute that is an on-balance sheet asset, e.g., a retained or
purchased subordinated security, a bank must maintain capital
against the amount of the on-balance sheet asset plus the full
amount of the assets not on the bank's balance sheet that are being
supported, i.e., all more senior positions.
   (ii) Determining the credit risk weight of investment grade
recourse obligations, direct credit substitutes, and asset- and
mortgage-backed securities. Notwithstanding paragraph B.5.(b)(i) of
this section, a traded position is eligible for the following risk-
based capital treatment. A recourse obligation or direct credit
substitute that is not a traded position also is eligible for the
following treatment if it has been rated at least investment grade
by two nationally recognized statistical rating organizations, the
ratings are publicly available, the ratings are based on the same
criteria used to rate securities sold to the public, and the
recourse obligation or direct credit substitute provides credit
enhancement to a securitization in which there is at least one
traded position.
   (1) Highest investment grade. The face amount of a recourse
obligation, direct credit substitute, or an asset- or mortgage-
backed security that is rated in the highest investment grade
category is assigned to the 20 percent risk category.
   (2) Other investment grade. [Option 1--Face Value Treatment] The
face amount of a recourse obligation, direct credit substitute, or
an asset- or mortgage-backed security that is rated investment grade
(but not in the highest investment grade category) is assigned to
the 100 percent risk category.
   [Option 2--Modified Gross-Up] For a recourse obligation, direct
credit substitute, or an asset- or mortgage-backed security that is
rated investment grade (but not in the highest investment grade
category), the full amount of the credit enhanced assets from which
risk of credit loss is directly or indirectly retained or assumed by
the bank is assigned to the 50 percent risk category, regardless of
the face amount of the bank's risk position. For a senior asset-or
mortgage-backed security which provides no credit enhancement, this
means that the face amount of the security is assigned to the 50
percent risk category.
   (iii) Risk participations and syndications in direct credit
substitutes. (1) In the case of a direct credit substitute in which
a risk participation 14 has been conveyed, the full
amount of the credit enhanced assets from which risk of credit loss
is directly or indirectly retained or assumed, in whole or in part,
by the direct credit substitute is converted to a credit equivalent
amount at 100 percent. However, the pro rata share of the credit
equivalent amount that has been conveyed through a risk
participation is assigned to whichever risk category is lower: The
risk category appropriate to the obligor, after considering any
relevant guarantees or collateral, or the risk category appropriate
to the institution acquiring the participation.15 Any
remainder of the credit equivalent amount is assigned to the risk
category appropriate to the obligor, guarantor, or collateral. For
example, the pro rata share of the full amount of the assets
supported, in whole or in part, by a direct credit substitute
conveyed as a risk participation to a U.S. domestic depository
institution or foreign bank is assigned to the 20 percent risk
category. 16
---------------------------------------------------------------------------

   \14\ That is, a participation in which the originating bank
remains liable to the beneficiary for the full amount of the direct
credit substitute if the party that has acquired the participation
fails to pay when the instrument is drawn.
   \15\ A risk participation in a bankers acceptance conveyed to
another institution is also assigned to the risk category
appropriate to the institution acquiring the participation or, if
relevant, the guarantor or nature of the collateral.
   \16\ A risk participation with a remaining maturity of over one
year that is conveyed to a non-OECD bank is to be assigned to the
100 percent risk category, unless a lower risk category is
appropriate to the obligor, guarantor, or collateral.
---------------------------------------------------------------------------

   (2) The capital treatment for risk participations, either
conveyed or acquired, and syndications in direct credit substitutes
that are associated with an asset securitization and are rated at
least investment grade is set forth in paragraph B.5.(b)(ii) of this
section. A lower risk category may be applicable depending on the
obligor or nature of the institution acquiring the participation.
   (3) In the case of a direct credit substitute in which a risk
participation has been acquired, the acquiring bank's percentage
share of the direct credit substitute is multiplied by the full
amount of the credit enhanced assets from which risk of credit loss
is directly or indirectly retained or assumed, in whole or in part,
by the direct credit substitute and is converted to a credit
equivalent amount at 100 percent. The credit equivalent amount of an
acquisition of a risk participation in a direct credit substitute is
assigned to the risk category appropriate to the account party
obligor or, if relevant, the nature of the collateral or guarantees.
   (4) In the case of a direct credit substitute that takes the
form of a syndication where each bank is obligated only for its pro
rata share of the risk and there is no recourse to the originating
bank, each bank will only include in its risk-based capital
calculation only its pro rata share of the credit enhanced assets
from which risk of credit loss is directly or indirectly retained or
assumed, in whole or in part, by the direct credit substitute.
17
---------------------------------------------------------------------------

   \17\ For example, if a bank has a 10 percent share of a $10
syndicated direct credit substitute that provides credit support to
a $100 loan, then the bank's $1 pro rata share in the enhancement
means that a $10 pro rata share of the loan is included in risk-
weighted assets.
---------------------------------------------------------------------------

   (c) Limitations on risk-based capital requirements. (i) Low-
level recourse. If the maximum contractual liability or exposure to
loss retained or assumed by a bank in connection with a recourse

[[Page 59972]]

obligation or a direct credit substitute is less than the amount of
capital which would be held under the applicable risk-based capital
requirement for the enhanced assets, the bank need only hold capital
equal to the maximum contractual liability or exposure to loss, less
any recourse liability account established in accordance with generally
accepted accounting principles. This exception does not apply to assets
sold with implicit recourse.
   (ii) Mortgage-related securities or participation certificates
retained in a mortgage loan swap. If a bank holds a mortgage-related
security or a participation certificate as a result of a mortgage
loan swap with recourse, capital is required to support the recourse
obligation plus the percentage of the mortgage-related security or
participation certificate that is not covered by the recourse
obligation. The total amount of capital required for the on-balance
sheet asset and the recourse obligation, however, is limited to the
capital requirement for the underlying loans, calculated as if the
bank continued to hold these loans as an on-balance sheet asset.
   (iii) Related on-balance sheet assets. If a recourse obligation
or direct credit substitute subject to section II.B.5. of this
appendix A also appears as an on-balance sheet asset, the credit
equivalent amount of the recourse obligation or direct credit
substitute is determined in accordance with paragraph B.5.(b) of
this section and the balance sheet asset is not separately included
in a bank's risk-weighted assets, except in the case of mortgage
servicing assets and similar arrangements with embedded recourse
obligations or direct credit substitutes. In such cases, both the
on-balance sheet assets and the related recourse obligations and
direct credit substitutes are incorporated into the risk-based
capital calculation.
   (d) Privately-issued mortgage-backed securities. Generally, a
privately-issued mortgage-backed security meeting certain criteria,
set forth in the accompanying footnote, 18 is essentially
treated as an indirect holding of the underlying assets, and
assigned to the same risk category as the underlying assets, but in
no case to the zero percent risk category. However, any class of a
privately-issued mortgage-backed security whose structure does not
qualify it to be regarded as an indirect holding of the underlying
assets or that can absorb more than its pro rata share of loss
without the whole issue being in default (for example, a so-called
subordinated class) is treated in accordance with paragraph B.5.(b)
of this section. Furthermore, all privately-issued stripped
mortgage-backed securities, including interest-only strips (IOs),
principal-only strips (POs), and similar instruments, are assigned
to the 100 percent risk weight category, regardless of the issuer or
guarantor.
---------------------------------------------------------------------------

   \18\ A privately-issued mortgage-backed security may be treated
as an indirect holding of the underlying assets provided that: (1)
The underlying assets are held by an independent trustee and the
trustee has a first priority, perfected security interest in the
underlying assets on behalf of the holders of the security; (2)
either the holder of the security has an undivided pro rata
ownership interest in the underlying mortgage assets or the trust or
single purpose entity (or conduit) that issues the security has no
liabilities unrelated to the issued securities; (3) the security is
structured such that the cash flow from the underlying assets in all
cases fully meets the cash flow requirements of the security without
undue reliance on any reinvestment income; and (4) there is no
material reinvestment risk associated with any funds awaiting
distribution to the holders of the security. In addition, if the
underlying assets of a mortgage-backed security are composed of more
than one type of asset, the entire mortgage-backed security is
generally assigned to the category appropriate to the highest risk-
weighted asset underlying the issue.
---------------------------------------------------------------------------

   (e) Other stripped mortgage-backed securities. All other
stripped mortgage-backed securities, including interest-only strips
(IOs), principal-only strips (POs), and similar instruments, are
assigned to the 100 percent risk weight category, regardless of the
issuer or guarantor.
* * * * *
   3. In appendix A to part 325, section II.C., Category 1 through
Category 3, footnotes 15 through 32 are redesignated as footnotes 19
through 36, the four undesignated paragraphs under Category 3--50
Percent Risk Weight are designated as paragraphs a. through d.,
respectively, and newly redesignated footnote 33 is revised to read as
follows:
* * * * *
   II. * * *
   C. * * *
   Category 3--50 Percent Risk Weight. * * *
   b. * * * \33\ * * *
---------------------------------------------------------------------------

   \33\ The types of loans that qualify as loans secured by
multifamily residential properties are listed in the instructions
for preparation of the Consolidated Reports of Condition and Income.
In addition, from the standpoint of the selling bank, when a
multifamily residential property loan is sold subject to a pro rata
loss sharing arrangement which provides for the purchaser of the
loan to share in any loss incurred on the loan on a pro rata basis
with the selling bank, that portion of the loan is not subject to
the risk-based capital standards. In connection with sales of
multifamily residential property loans in which the purchaser of the
loan shares in any loss incurred on the loan with the selling
institution on other than a pro rata basis, the selling bank must
treat these other loss sharing arrangements in accordance with
section II.B.5. of this appendix A.
---------------------------------------------------------------------------

* * * * *
   4. In appendix A to part 325, section II.C., Category 4--100
Percent Risk Weight is revised to read as follows:
* * * * *
   II. * * *
   C. * * *
   Category 4--100 Percent Risk Weight. a. All assets not included
in the categories above are assigned to this category, which
comprises standard risk assets. The bulk of the assets typically
found in a loan portfolio would be assigned to the 100 percent
category.
   b. This category includes:
   (1) Long-term claims on, and the portions of long-term claims
that are guaranteed by, non-OECD banks, and all claims on non-OECD
central governments that entail some degree of transfer risk;
37
---------------------------------------------------------------------------

   \37\ Such assets include all nonlocal-currency claims on, and
the portions of claims that are guaranteed by, non-OECD central
governments and those portions of local-currency claims on, or
guaranteed by, non-OECD central governments that exceed the local-
currency liabilities held by subsidiary depository institutions.
---------------------------------------------------------------------------

   (2) All claims on foreign and domestic private-sector obligors
not included in the categories above (including loans to
nondepository financial institutions and bank holding companies);
   (3) Claims on commercial firms owned by the public sector;
   (4) Customer liabilities to the bank on acceptances outstanding
involving standard risk claims; 38
---------------------------------------------------------------------------

   \38\ Customer liabilities on acceptances outstanding involving
nonstandard risk claims, such as claims on U.S. depository
institutions, are assigned to the risk category appropriate to the
identity of the obligor or, if relevant, the nature of the
collateral or guarantees backing the claims. Portions of acceptances
conveyed as risk participations to U.S. depository institutions or
foreign banks are assigned to the 20 percent risk category
appropriate to short-term claims guaranteed by U.S. depository
institutions and foreign banks.
---------------------------------------------------------------------------

   (5) Investments in fixed assets, premises, and other real estate
owned;
   (6) Common and preferred stock of corporations, including stock
acquired for debts previously contracted;
   (7) Commercial and consumer loans (except (a) those assigned to
lower risk categories due to recognized guarantees or collateral and
(b) loans secured by residential property that qualify for a lower
risk weight);
   (8) All stripped mortgage-backed securities and similar
instruments;
   (9) Industrial-development bonds and similar obligations issued
under the auspices of state or political subdivisions of the OECD-
based group of countries for the benefit of a private party or
enterprise where that party or enterprise, not the government
entity, is obligated to pay the principal and interest; and
   (10) All obligations of states or political subdivisions of
countries that do not belong to the OECD-based group of countries.
   c. The following assets also are assigned a risk weight of 100
percent if they have not been deducted from capital: investments in
unconsolidated subsidiaries, joint ventures, or associated
companies; instruments that qualify as capital issued by other
banking organizations; and servicing assets and intangible assets.
* * * * *
   5. In appendix A to part 325, section II.D. is amended by
redesignating footnotes 38 through 42 as footnotes 41 through 45 and
by revising the undesignated introductory

[[Page 59973]]

paragraph of section II.D. and section II.D.1. to read as follows:
* * * * *
   II. * * *
   D. * * *
   The face amount of an off-balance sheet item is generally
incorporated into risk-weighted assets in two steps. The face amount
is first multiplied by a credit conversion factor, except for direct
credit substitutes and recourse obligations as discussed in section
II.D.1. of this appendix A. The resultant credit equivalent amount
is assigned to the appropriate risk category according to the
obligor or, if relevant, the guarantor or the nature of the
collateral.39
---------------------------------------------------------------------------

   \39\ The sufficiency of collateral and guarantees for off-
balance-sheet items is determined by the market value of the
collateral of the amount of the guarantee in relation to the face
amount of the item, except for derivative contracts, for which this
determination is generally made in relation to the credit equivalent
amount. Collateral and guarantees are subject to the same provisions
noted under section II.B. of this appendix A.
---------------------------------------------------------------------------

   1. Items With a 100 Percent Conversion Factor. a. Except as
otherwise provided in section II.B.5. of this appendix A, the full
amount of an asset or transaction supported, in whole or in part, by
a direct credit substitute or a recourse obligation. Direct credit
substitutes and recourse obligations are defined in section II.B.5.
of this appendix A.
   b. Sale and repurchase agreements, if not already included on
the balance sheet, and forward agreements. Forward agreements are
legally binding contractual obligations to purchase assets with
drawdown which is certain at a specified future date. These
obligations include forward purchases, forward deposits
placed, 40 and partly-paid shares and securities, but
they do not include commitments to make residential mortgage loans
or forward foreign exchange contracts.
---------------------------------------------------------------------------

   \40\ Forward deposits accepted are treated as interest
rate contracts.
---------------------------------------------------------------------------

   c. Securities lent by a bank are treated in one of two ways,
depending on whether the lender is exposed to risk of loss. If a
bank, as agent for a customer, lends the customer's securities and
does not indemnify the customer against loss, then the securities
lending transaction is excluded from the risk-based capital
calculation. On the other hand, if a bank lends its own securities
or, acting as agent for a customer, lends the customer's securities
and indemnifies the customer against loss, the transaction is
converted at 100 percent and assigned to the risk weight category
appropriate to the obligor or, if applicable, to any collateral
delivered to the lending bank or the independent custodian acting on
the lending bank's behalf. When a bank is acting as a customer's
agent in a transaction involving the loan or sale of the customer's
securities that is collateralized by cash delivered to the lending
bank, the transaction is deemed to be collateralized by cash on
deposit with the bank for purposes of determining the appropriate
risk-weight category, provided that any indemnification is limited
to no more than the difference between the market value of the
securities lent or sold and the cash collateral received, and any
reinvestment risk associated with the cash collateral is borne by
the customer.
* * * * *
   6. In appendix A to part 325, Table II--Summary of Risk Weights and
Risk Categories is amended under Category 2--20 Percent Risk Weight by
adding a new paragraph (13) to read as follows:
* * * * *

Table II--Summary of Risk Weights and Risk Categories

* * * * *
   Category 2--20 Percent Risk Weight
* * * * *
   (13) The face amount of a recourse obligation, direct credit
substitute, or asset- or mortgage-backed security that is rated in
the highest investment grade category.
* * * * *
   7. In appendix A to part 325, Table II--Summary of Risk Weights and
Risk Categories is amended under Category 3--50 Percent Risk Weight by
adding a new paragraph (6) to read as follows:
* * * * *

Table II--Summary of Risk Weights and Risk Categories

* * * * *

Category 3--50 Percent Risk Weight

* * * * *
   [Option 2--Modified Gross-Up] (6) The full amount of the credit
enhanced assets from which risk of credit loss is directly or
indirectly retained or assumed through a recourse obligation, direct
credit substitute, or asset- or mortgage-backed security that is
rated investment grade (but below the highest investment grade
category).
* * * * *
   8. In appendix A to part 325, Table III--Credit Conversion Factors
for Off-Balance Sheet Items, the item ``100 Percent Conversion Factor''
is revised and a new item ``Credit Conversion for Recourse Obligations
and Direct Credit Substitutes'' is added after the item ``Zero Percent
Conversion Factor'' to read as follows:
* * * * *

Table III--Credit Conversion Factors for Off-Balance Sheet Items 100
Percent Conversion Factor

100 Percent Conversion Factor

   (1) Sale and repurchase agreements, if not already included on
the balance sheet.
   (2) Forward agreements representing contractual obligations to
purchase assets, including financing facilities, with drawdown
certain at a specified future date.
   (3) Securities lent, if the lending bank is exposed to risk of
loss.
* * * * *

Credit Conversion for Recourse Obligations and Direct Credit
Substitutes

   The credit equivalent amount for an off-balance sheet recourse
obligation or direct credit substitute:
   (1) That is not rated at least investment grade is the full
amount of the credit enhanced assets from which risk of loss is
directly or indirectly retained or assumed, subject to the low-level
recourse rule.
   (2) That is rated in the highest investment grade category is
its face amount.
   (3) That is rated investment grade, but below the highest
investment grade category, is [Option 1--Face Value Treatment] its
face amount.
   [Option 2--Modified Gross-Up] the full amount of the credit
enhanced assets from which risk of credit loss is directly or
indirectly retained or assumed.
* * * * *
   Dated at Washington, D.C., this 16th day of September, 1997.
Federal Deposit Insurance Corporation.
   By order of the Board of Directors.

Robert E. Feldman,
Executive Secretary.

Office of Thrift Supervision

12 CFR CHAPTER V

Authority and Issuance

   For the reasons set out in the preamble, part 567 of chapter V of
title 12 of the Code of Federal Regulations is proposed to be amended
as follows:

PART 567--CAPITAL

   1. The authority citation for part 567 continues to read as
follows:

   Authority: 12 U.S.C. 1462, 1462a, 1463, 1464, 1467a, 1828(note).

   2. Section 567.1 is amended by removing and reserving paragraph
(f), by removing in paragraph (i)(2) including text the phrase
``Sec. 567.6(a)(vi)'' and adding in lieu thereof the phrase
``Sec. 567.6(a)(1)(vi)'' and by revising paragraph (kk), to read as
follows:

Sec. 567.1  Definitions.

* * * * *
   (kk) Standby letter of credit. (1) Financial guarantee-type standby
letter of credit means any letter of credit or similar arrangement,
however named or described, that represents an irrevocable obligation
to the beneficiary on the part of the issuer:
   (i) To repay money borrowed by, advanced to, or for the account of
an account party; or
   (ii) To make payment on account of any indebtedness undertaken by
an account party, in the event that the account party fails to fulfill
its obligation to the beneficiary.
   (2) Performance-based standby letter of credit means any letter of
credit, or similar arrangement, however named or described, which
represents an irrevocable obligation to the beneficiary on the part of
the issuer to make payment on account of any default by a

[[Page 59974]]

third party in the performance of a nonfinancial or commercial
obligation.
* * * * *
   3. Section 567.6 is amended by revising paragraphs (a) heading and
introductory text, (a)(1) introductory text, and (a)(2) introductory
text, removing and reserving paragraphs (a)(2)(i)(A) and (C), revising
paragraphs (a)(2)(i)(B) and (a)(3), and adding paragraph (b) to read as
follows:

Sec. 567.6  Risk-based capital credit risk-weight categories.

   (a) Risk-weighted assets. Risk-weighted assets equal risk-weighted
on-balance sheet assets (as computed under paragraph (a)(1) of this
section), plus risk-weighted off-balance sheet items (as computed under
paragraph (a)(2) of this section), plus risk-weighted recourse
obligations, direct credit substitutes, and asset-and mortgage-backed
securities (as computed under paragraph (a)(3) of this section). Assets
not included for purposes of calculating capital pursuant to Sec. 567.5
are not included in calculating risk-weighted assets.
   (1) On-balance sheet assets. Except as provided in paragraph (a)(3)
of this section, risk-weighted on-balance sheet assets are computed by
multiplying the on-balance sheet asset amount times the appropriate
risk weight categories. The risk weight categories for on-balance sheet
assets are:
* * * * *
   (2) Off-balance sheet activities. Except as provided in paragraph
(a)(3) of this section, risk-weights for off-balance sheet items are
determined by the following two-step process. First, the face amount of
the off-balance sheet item must be multiplied by the appropriate credit
conversion factor listed in this paragraph (a)(2). This calculation
translates the face amount of an off-balance sheet exposure into an on-
balance sheet credit-equivalent amount. Second, the credit-equivalent
amount must be assigned to the appropriate risk weight category using
the criteria regarding obligors, guarantors, and collateral listed in
paragraph (a)(1) of this section, provided that the maximum risk weight
assigned to the credit-equivalent amount of an interest-rate or
exchange-rate contract is 50 percent. The following are the credit
conversion factors and the off-balance sheet items to which they apply:
   (i) * * *
   (B) Risk participations purchased in bank acceptances;
* * * * *
   (3) Recourse obligations, direct credit substitutes, and asset- and
mortgage-backed securities--(i) Risk-weighted asset amount. Except as
otherwise provided in this paragraph (a)(3), to calculate the risk-
weighted asset amount for a recourse obligation or a direct credit
substitute, multiply the amount of assets from which risk of credit
loss is directly or indirectly retained or assumed, by the appropriate
risk weight using the criteria regarding obligors, guarantors, and
collateral listed in paragraph (a)(1) of this section. For purposes of
this paragraph (a)(3), the amount of assets from which risk of credit
loss is directly or indirectly retained or assumed means:
   (A) For a financial guarantee-type standby letter of credit, surety
arrangement, guarantee, or irrevocable guarantee-type instrument, the
amount of assets that the direct credit substitute fully or partially
supports;
   (B) For a subordinated interest or security, the amount of the
subordinated interest or security, plus all more senior interests or
securities;
   (C) For mortgage servicing rights that are recourse obligations or
direct credit substitutes, the outstanding amount of the loans
serviced;
   (D) For representations and warranties (other than standard
representations and warranties), the amount of the assets subject to
the representations or warranties;
   (E) For loans on lines of credit that provide credit enhancement
for the financial obligations of the financial obligations of an
account party, the amount of the enhanced financial obligations;
   (F) For loans strips, the amount of the loans; and
   (G) For assets sold with recourse, the amount of assets from which
risk of credit loss is directly or indirectly retained, less any
applicable recourse liability account established in accordance with
generally accepted accounting principles. Other types of recourse
obligations or direct credit substitutes should be treated in
accordance with the principles contained in this paragraph (a)(3)(i).
   (ii) Investment grade recourse obligations, direct credit
substitutes, and asset-and mortgage-backed securities.--(A)
Eligibility. A traded position in an asset-or mortgage-backed
securitization is eligible for the treatment described in this
paragraph (a)(3)(ii), if it has been rated investment grade by a
nationally recognized statistical rating organization. A recourse
obligation or direct credit substitute that is not a traded position is
eligible for the treatment described in this paragraph (a)(3)(ii) if it
has been rated investment grade by two nationally recognized
statistical rating organizations, the ratings are publicly available,
the ratings are based on the same criteria used to rate securities sold
to the public, and the recourse obligation or direct credit substitute
provide credit enhancement to a securitization in which at least one
position is traded.
   (B) Highest investment grade. To calculate the risk-weighted asset
amount for a recourse obligation, direct credit substitute, or asset-or
mortgage-backed security that is rated in the highest investment grade
category, multiply the face amount of the position by a risk weight of
20 percent.
   (C) Other investment grade. [Option I--Face Value Treatment] To
calculate the risk-weighted asset amount for a recourse obligation,
direct credit substitute, or asset-or mortgage-backed security that is
rated investment grade, multiply the face amount of the position by a
risk weight of 100 percent.
   [Option II--Modified Gross-Up Treatment] To calculate the risk-
weighted asset amount for a recourse obligation, direct credit
substitute, or asset-or mortgage backed security that is rated
investment grade, multiply the amount of assets from which risk of
credit loss is directly or indirectly retained or assumed (see
paragraphs (a)(3)(i)(A) through (F) of this section), by a risk weight
of 50 percent.
   (iii) Participations. The risk-weighted asset amount for a
participation interest in a recourse obligation or direct credit
substitute is calculated as follows:
   (A) Determine the risk-weighted asset amount for the recourse
obligation or direct credit substitute as if the savings association
held all of the interests in the participation;
   (B) Multiply this amount by the percentage of the savings
association's participation interest; and
   (C) If the savings association is exposed to more than its pro rata
share of the risk of credit loss on the recourse obligation or direct
credit substitute (e.g., the savings association remains secondarily
liable on participations held by others), add to the amount computed
under paragraph (a)(3)(iii)(B) of this section, an amount computed as
follows: Multiply the amount of the recourse obligation or direct
credit substitute by the percentage of the recourse obligation or
direct credit substitute held by others and then multiply the result by
the lesser of the risk weight appropriate for the holders of those
interests or the risk weight appropriate to the recourse obligation or
direct credit substitute.
   (iv) Alternative capital computation for small business
obligations.

[[Page 59975]]

   (A) Definitions. For the purposes of this paragraph (a)(3)(iv):
   (1) Qualified savings association means a savings association that:
   (i) Is well capitalized as defined in Sec. 565.4 of this chapter
without applying the capital treatment described in paragraph
(a)(3)(iv)(B) of this section; or
   (ii) Is adequately capitalized as defined in Sec. 565.4 of this
chapter without applying the capital treatment described in paragraph
(a)(3)(iv)(B) of this section and has received written permission from
the OTS to apply that capital calculation.
   (2) Small business means a business that meets the criteria for a
small business concern established by the Small Business Administration
in 12 CFR part 121 pursuant to 15 U.S.C. 632.
   (B) Capital requirement. With respect to a transfer of a small
business loan or lease of personal property with recourse that is a
sale under generally accepted accounting principles, a qualified
savings association may elect to include only the amount of its
retained recourse in its risk-weighted assets for the purposes of this
paragraph (a)(3). To qualify for this election, the savings association
must establish and maintain a reserve under generally accepted
accounting principles sufficient to meet the reasonable estimated
liability of the savings association under the recourse obligation.
   (C) Aggregate amount of recourse. The total outstanding amount of
recourse retained by a qualified savings association with respect to
transfers of small business loans and leases of personal property and
included in the risk-weighted assets of the savings association as
described in this paragraph (a)(3), may not exceed 15 percent of the
association's total capital computed under Sec. 567.5(c)(4).
   (D) Savings association that ceases to be a qualified savings
association or that exceeds aggregate limits. If a savings association
ceases to be a qualified savings association or exceeds the aggregate
limit described in paragraph (a)(3)(iv)(C) of this section, the savings
association may continue to apply the capital treatment described in
paragraph (a)(3)(iv)(B) of this section to transfers of small business
loans and leases of personal property that occurred when the
association was a qualified savings association and did not exceed the
limit.
   (E) Prompt corrective action not affected. (1) A savings
association shall compute its capital without regard to this paragraph
(a)(3)(iv) of this section for purposes of prompt corrective action (12
U.S.C. 1831o), unless the savings association is adequately or well
capitalized without applying the capital treatment described in this
paragraph (a)(3)(iv) and would be well capitalized after applying that
capital treatment.
   (2) A savings association shall compute its capital requirement
without regard to this paragraph (a)(3)(iv) for the purposes of
applying 12 U.S.C. 1381o(g), regardless of the association's capital
level.
   (v) Limitations on risk-based capital requirements.--(A) Low level
recourse. (1) If the maximum contractual liability or exposure to
credit loss retained or assumed by a savings association in connection
with a recourse obligation or a direct credit substitute is less than
the effective risk-based capital requirement for the enhanced asset,
the risk based capital requirement is limited to the maximum
contractual liability or exposure to credit loss. For assets sold with
recourse, the amount of capital required to support the recourse
obligation is limited to the maximum contractual liability or exposure
to credit loss less the amount of the recourse liability account
established in accordance with generally accepted accounting
principles.
   (2) The low level recourse limitation does not apply to assets sold
with implicit recourse.
   (B) Mortgage-related securities or participation certificates
retained in a mortgage loan swap. If a savings association holds a
mortgage-related security or a participation certificate as a result of
a mortgage loan swap with recourse, capital is required to support the
recourse obligation (including consideration of any low level recourse
limitation described at paragraph (a)(3)(v)(A) of this section), plus
the percentage of the mortgage-related security or participation
certificate that is not protected against risk of loss by the recourse
obligation. The total amount of capital required for the on-balance
sheet asset and the recourse obligation, however, is limited to the
capital requirement for the underlying loans, calculated as if the
savings association continued to hold these loans as an on-balance
sheet asset.
   (C) Related on-balance sheet assets. To the extent that an asset is
included in the calculation of the risk-based capital requirement under
this paragraph (a)(3), and may also be included as an on-balance sheet
asset under paragraph (a)(1) of this section, the asset shall be risk-
weighted only under this paragraph (a)(3) except:
   (1) Mortgage servicing assets and similar arrangements with
embedded recourse obligations or direct credit substitutes are risk
weighted as on-balance sheet assets under paragraph (a)(1) of this
section, and the related recourse obligations and direct credit
substitutes are risk-weighted under this paragraph (a)(3); and
   (2) Purchased subordinated interests that are high quality
mortgage-related securities are not subject to risk weighting under
this paragraph (a)(3). Rather, the face values of these assets are
risk-weighted as on-balance sheet assets under paragraph (a)(1)(ii)(H)
of this section.
   (vi) Obligations of subsidiaries. If a savings association retains
a recourse obligation or assumes a direct credit substitute on the
obligation of a subsidiary that is not an includable subsidiary, and
the recourse obligation or direct credit substitute is an equity or
debt investment in that subsidiary under generally accepted accounting
principles, the face amount of the recourse obligation or direct credit
substitute is deducted for capital under Secs. 567.5(a)(2) and
567.9(c). All other recourse obligations and direct credit substitutes
retained or assumed by a savings association on the obligations of an
entity in which the savings association has an equity investment are
risk-weighted in accordance with paragraphs (a)(3)(i) through (v) of
this section.
   (b) Definitions. For the purposes of this section:
   (1) Direct credit substitute means an arrangement in which a
savings association assumes, in form or in substance, any risk of
credit loss directly or indirectly associated with a third party asset
or other financial claim, that exceeds the savings association's pro
rata share of the asset or claim. If a savings association has no claim
on an asset, then the assumption of any risk of credit loss is a direct
credit substitute. Direct credit substitutes include, but are not
limited to:
   (i) Financial guarantee-type standby letters of credit that support
financial claims on the account party;
   (ii) Guarantees, surety arrangements, and irrevocable guarantee-
type instruments backing financial claims;
   (iii) Purchased subordinated interests or securities that absorb
more than their pro rata share of losses from the underlying assets;
   (iv) Loans or lines of credit that provide credit enhancement for
the financial obligations of an account party; and
   (v) Purchased loan servicing assets if the servicer is responsible
for credit losses associated with the loans being serviced (other than
a servicer cash advance as defined in this section), or if the servicer
makes or assumes

[[Page 59976]]

representations and warranties on the loans other than standard
representation and warranties as defined in this section.
   (2) Rated means, with respect to an instrument or obligation, that
the instrument or obligation has received a credit rating from a
nationally-recognized statistical rating organization. An instrument or
obligation is rated investment grade if it has received a credit rating
that falls within one of the four highest rating categories used by the
organization. An instrument or obligation is rated in the highest
investment grade if it has received a credit rating that falls within
the highest rating category used by the organization.
   (3) Recourse means the retention, in form or in substance, of any
risk of credit loss directly or indirectly associated with a
transferred asset, that exceeds a pro rata share of the savings
association's claim on the asset. If a savings association has no claim
on a transferred asset, then the retention of any risk of credit loss
is recourse. A recourse obligation typically arises when an institution
transfers its assets and retains an obligation to repurchase the
assets, or to absorb losses due to a default of principal or interest
or any other deficiency in the performance of the underlying obligor or
some other party. Recourse may exist implicitly where a savings
association provides credit enhancement beyond any contractual
obligation to support the assets it has sold. Recourse obligations
include, but are not limited to:
   (i) Representations and warranties on the transferred assets other
than standard representations and warranties as defined in this
section;
   (ii) Retained loan servicing assets if the servicer is responsible
for losses associated with the loans serviced (other than a servicer
cash advance as defined in this section);
   (iii) Retained subordinated interests or securities that absorb
more than their pro rata share of losses from the underlying assets;
   (iv) Assets sold under an agreement to repurchase; and
   (v) Loan strips sold without direct recourse where the maturity of
the transferred loan is shorter than the maturity of the commitment.
   (4) Servicer cash advance means funds that a residential mortgage
loan servicer advances to ensure an uninterrupted flow of payments or
the timely collection of residential mortgage loans, including
disbursements made to cover foreclosure costs or other expenses arising
from a mortgage loan to facilitate its timely collection. A servicer
cash advance is not a recourse obligation or a direct credit substitute
if:
   (i) The mortgage servicer is entitled to full reimbursement; or
   (ii) For any one residential mortgage loan, nonreimbursed advances
are contractually limited to an insignificant amount of the outstanding
principal on that loan.
   (5) Standard representations and warranties mean contractual
provisions that a savings association extends when it transfers assets
(including loan servicing assets) or assumes when it purchases loan
servicing assets. To qualify as a standard representation or warranty,
a contractual provision must:
   (i) Refer to facts that the seller or servicer can verify, and has
verified with reasonable due diligence, prior to the time that assets
are transferred (or servicing assets are acquired);
   (ii) Refer to a condition that is within the control of the seller
or servicer; or
   (iii) Provide for the return of assets in the event of fraud or
documentation deficiencies.
   (6) Traded position means a recourse obligation, direct credit
substitute, or asset- or mortgage-backed security that is retained,
assumed or issued in connection with an asset securitization, and that
was rated with a reasonable expectation that, in the near future:
   (i) The position would be sold to investors relying on the rating;
or
   (ii) A third party would, in reliance on the rating, enter into a
transaction such as a loan or repurchase agreement involving the
position.

   Dated: September 3, 1997.

   By the Office of Thrift Supervision.
Nicolas P. Retsinas,
Director.
[FR Doc. 97-28828 Filed 11-4-97; 8:45 am]
BILLING CODES: 4810-33-P, 6210-01-P, 6714-01-P, 6720-01-P