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l l★K

Federal Reserve Bank
of Dallas

June 13, 2002

DALLAS, TEXAS
75265-5906

Notice 02-30

TO: The Chief Executive Officer of each state
member bank, bank holding company and foreign
entity in the Eleventh Federal Reserve District

SUBJECT
Interagency Questions and Answers
on the Capital Treatment of Recourse, Direct Credit Substitutes,
and Residual Interests in Asset Securitizations
DETAILS
On November 29, 2001, the Federal Reserve and the other federal banking agencies
published a final rule on the Capital Treatment of Recourse, Direct Credit Substitutes, and
Residual Interests in Asset Securitizations. Since the rule became effective January 1, 2002, the
industry has raised several questions regarding the appropriate application of certain aspects of
the rule.
In response, the federal banking agencies jointly developed a question-and-answer
document that provides interpretive guidance on some of these issues. Further guidance will be
provided as necessary.
ATTACHMENT
A copy of the interagency document dated May 23, 2002, is attached.
MORE INFORMATION
For more information, please contact Gayle Teague, Banking Supervision Department, at (214) 922-6151. Paper copies of this notice or previous Federal Reserve Bank notices
can be printed from our web site at http://www.dallasfed.org/banking/notices/index.html.

For additional copies, bankers and others are encouraged to use one of the following toll-free numbers in contacting the Federal
Reserve Bank of Dallas: Dallas Office (800) 333-4460; El Paso Branch Intrastate (800) 592-1631, Interstate (800) 351-1012;
Houston Branch Intrastate (800) 392-4162, Interstate (800) 221-0363; San Antonio Branch Intrastate (800) 292-5810.

Board of Governors of the Federal Reserve System
Federal Deposit Insurance Corporation
Office of the Comptroller of the Currency
Office of Thrift Supervision
Interagency Questions and Answers on the Capital Treatment of Recourse, Direct Credit
Substitutes, and Residual Interests in Asset Securitizations
Purpose
The Office of the Comptroller of the Currency (OCC), the Federal Deposit Insurance
Corporation (FDIC), the Federal Reserve Board (Board), and the Office of Thrift Supervision
(OTS) (the Agencies) published a final rule on the Capital Treatment of Recourse, Direct Credit
Substitutes and Residual Interests in Asset Securitizations in November of 2001.1 The rule
became effective on January 1, 2002, and has generated several questions from the industry
regarding proper implementation and application. This question-and-answer document provides
interpretive guidance on issues raised by the final rule. Further guidance will be provided, as
necessary.
I. Scope and Definitions
A. Are spread accounts that function as credit enhancements “credit-enhancing interest-only
strips” and, therefore, subject to the concentration limit?
The final rule defines “credit-enhancing interest-only strip” as “an on-balance sheet asset that, in
form or in substance, (i) represents the contractual right to receive some or all of the interest due
on the transferred assets; and (ii) exposes the banking organization to credit risk that exceeds its
pro rata claim on the underlying assets whether through subordination provisions or other credit
enhancing techniques.”2 The preamble elaborates on this definition. “In determining whether a
particular interest cash flow functions as a credit-enhancing I/O strip, the Agencies will look to
the economic substance of the transaction, and will reserve the right to identify other cash flows
or spread-related assets as credit-enhancing I/O strips on a case-by-case basis.” 66 Fed. Reg.
59614, 59622 (emphasis added).
A spread account is an on-balance sheet asset that functions as a credit enhancement and that can
represent an interest in expected interest and fee cash flows derived from assets an organization
has sold into a securitization. In those cases, the spread account is considered to be a “creditenhancing interest-only strip” and is subject to the concentration limit. However, any portion of a
spread account that represents an interest in cash that has already been collected and is held by
the trustee is a “residual interest” subject to dollar-for-dollar capital, but not a credit enhancing
interest-only strip subject to the concentration limit.
1

66 Fed. Reg. 59614 (November 29, 2001).
12 CFR part 3, appendix A, § 4(a)(2) (OCC). See also 12 CFR parts 208 and 225, appendix A, § II.B.1.c. (Board);
12 CFR § 325.2(g)(1) (FDIC); 12 CFR § 567.1 (OTS) (emphasis added).

2

Date:

May 23, 2002

Page 1

For example, assume that a banking organization books a single spread account asset that is
derived from two separate cash flow streams:
(1) a receivable from the securitization trust that represents cash that has already accumulated in
the spread account. In accordance with the securitization documents, the cash will be returned to
the banking organization at some date in the future after having been reduced by amounts used to
reimburse investors for credit losses. Based on the date when the cash is expected to be paid out
to the banking organization, the present value of this asset is currently estimated to be $3.
(2) a projection of future cash flows that are expected to accumulate in the spread account. In
accordance with the securitization documents, the cash, to the extent collected, will also be
returned to the banking organization at some date in the future after having been reduced by
amounts used to reimburse investors for credit losses. Based on the date when the cash is
expected to be paid out to the banking organization, the present value of this asset is currently
estimated to be $2.
Both components of the spread account are considered to be residual interests under the current
capital standards because both represent on-balance sheet assets subject to more than their pro
rata share of losses on the underlying portfolio of sold assets. However, the $2 asset that
represents the banking organization's retained interest in future cash flows exposes the
organization to a greater degree of risk because the $2 asset presents additional uncertainty as to
whether it will ever be collected. This additional uncertainty associated with the recognition of
future subordinated excess cash flows results in the $2 asset being treated as a credit-enhancing
interest-only strip, a subset of residual interests.
Under the final rule, the face amount of all of the banking organization's credit-enhancing
interest-only strips is first subject to a 25% of Tier 1 capital concentration limit.3 Any portion of
this face amount that exceeds 25% of Tier 1 capital is deducted from Tier 1 capital. This limit
will affect both a banking organization’s risk-based and leverage capital ratios. The remaining
face amount of the banking organization's credit-enhancing interest-only strips, as well as the
face amount of the spread account receivable for cash already held in the trust, is subject to the
dollar-for-dollar capital requirement established for residual interests, which affects only the
risk-based capital ratios.
B. How are instruments that are derived from a securitization and assigned separate ratings for
principal and interest (split/partially-rated instruments) treated in the final rule?
The final rule does not specifically address the treatment of split/partially-rated instruments.
However, in its discussion of the ratings-based approach, the preamble to the final rule indicates
that the ratings-based approach “provides a way for the agencies to use determinations of credit
quality . . . to differentiate the regulatory capital treatment for loss positions representing
different gradations of risk.” 66 Fed. Reg. 59614, 59625. The rule contemplated treating each
3

Date:

For savings associations, the limit is 25% of core capital.

May 23, 2002

Page 2

“position” in its entirety. Thus, for those banking organizations that hold split/partially-rated
instruments, the Agencies will apply to the entire instrument the risk weight that corresponds to
the lowest component rating.4 For example, a purchased subordinated security where the
principal component is rated BBB, but the interest component is rated B, will be subject to the
gross-up treatment accorded to direct credit substitutes rated B or lower as set forth in the final
rule. Similarly, if a portion of an instrument is unrated, the entire position will be treated as if it
is unrated. In addition to this regulatory capital treatment, the Agencies may also, as appropriate,
adversely classify and require write-downs for other than temporary impairment on unrated and
below investment grade securities, including split/partially-rated securities.
C. Do corporate bonds or other securities not related in any way to a securitization or structured
finance program qualify for the ratings-based approach?
No. Only mortgage- and asset-backed securities, recourse obligations, direct credit substitutes,
and residual interests (except credit-enhancing interest-only strips) retained, assumed, or issued
in connection with a securitization or structured finance program, as defined in the rule, qualify
for the ratings-based approach.5 “Securitization” is defined as “the pooling and repackaging by a
special purpose entity of assets or other credit exposures that can be sold to investors.”6 A
“structured finance program” is defined as “a program where receivable interests and assetbacked securities issued by multiple participants are purchased by a special purpose entity that
repackages those exposures into securities that can be sold to investors.”7 Corporate debt
instruments, municipal bonds and other securities that are not related to a securitization or
structured finance program do not meet these definitions and, thus, do not qualify for the ratingsbased approach.
II. Effective Date
In a revolving securitization, would receivables sold after January 1, 2002, into a trust that
existed before January 1, 2002, be immediately subject to the final rule?
No. The preamble to the final rule states that “[a]ny transactions settled on or after January 1,
2002, are subject to this final rule.” It further states that “banking organizations that enter into
transactions before January 1, 2002, that result in increased capital requirements under the final
rule may delay the application of this rule to those transactions until December 31, 2002.” 66
Fed. Reg. 59614. The sale of receivables on or after January 1, 2002, into a trust that existed as
of December 31, 2001, would not trigger the immediate imposition of the capital requirements
contained in the final rule, provided the sale was required under the trust documents in effect on
4

The Agencies also remind banking organizations that the Agencies may “override the use of certain ratings or the
ratings on certain instruments, either on a case-by-case basis or through broader supervisory policy, if necessary or
appropriate to address the risk that an instrument poses to banking organizations.” 66 Fed. Reg. 59614, 59625.
5
See 12 CFR part 3, appendix A, § 4(d)(1); 12 CFR parts 208 and 225, appendix A, § III.B.3.c.i (Board); 12 CFR
part 325, appendix A, § II.B.5(d)(1) (FDIC); 12 CFR § 567.6(b)(3) (OTS).
6
12 CFR part 3, appendix A, § 4(a)(14) (OCC). See also 12 CFR parts 208 and 225, appendix A, § III.B.3.a.xiii
(Board); 12 CFR part 325, appendix A, § II.B.5(a)(14) (FDIC); 12 CFR § 567.1 (OTS).
7
12 CFR part 3, appendix A, § 4(a)(15) (OCC); 12 CFR parts 208 and 225, appendix A, § III.B.3.a.xiv. (Board); 12
CFR part 325, appendix A, § II.B.5(a)(15) (FDIC); 12 CFR § 567.1 (OTS).

Date:

May 23, 2002

Page 3

December 31, 2001. Instead, the capital requirements contained in the final rule would apply
beginning on December 31, 2002. Moreover, the establishment of any new trust on or after
January 1, 2002, would be considered a new “transaction” and would subject assets sold into that
trust, and any positions resulting from the securitization of those assets, to the final rule
immediately.
III. Clean-up Calls
A. Concerning the repurchase of assets pursuant to a clean-up call, the preamble to the final
rule states that a “banking organization should repurchase the loans at the lower of their
estimated fair value or their par value plus accrued interest.” 66 Fed. Reg. 59614, 59624. May
the banking organization determine an aggregate fair value for all repurchased assets or should
each repurchased loan be individually evaluated?
Banking organizations that repurchase assets as a result of the exercise of a clean-up call may do
so based on the aggregate fair value of all repurchased assets. The Agencies did not intend for
each individual loan remaining in the pool at the time a clean-up call is exercised to be
individually evaluated to determine its fair value. Rather, the overall repurchase price should
reflect the aggregate fair value of the assets being repurchased so that the banking organization is
not overpaying for the assets and, in so doing, providing credit support to the trust investors.
Supervisors will review the terms and conditions relating to the repurchase arrangements in
clean-up calls to ensure that transactions are done at the lower of fair value or par value plus
accrued interest. Banking organizations should be able to support their fair value estimates.
Should the Agencies conclude that a banking organization has repurchased assets at a price that
exceeds the lower of these two amounts, the clean-up call provisions in an organization's future
securitizations may be treated as recourse obligations or direct credit substitutes.
B. The final rule states that “clean-up calls that are 10% or less of the original pool balance
and that are exercisable at the option of the [banking organization]” are not recourse or direct
credit substitutes. May this treatment also apply to clean-up calls written with reference to less
than 10% of the outstanding principal amount of securities?
Yes. The Agencies will not require recourse or direct credit substitute treatment for clean-up
calls written with reference to 10% of the outstanding principal amount of the securities. The
purpose of treating large clean-up calls as recourse or direct credit substitutes is to ensure that
banking organizations are not able to provide credit support to the trust investors by repaying
their investment when the credit quality of the pool is deteriorating without holding capital
against the exposure.8 A clean-up call based on 10% of outstanding securities would not defeat
the purpose of the rule and, oftentimes, may be a more conservative benchmark than 10% of the
pool balance.

8

Date:

See 66 Fed. Reg. 59614, 59623-4 (preamble discussion of clean-up calls).

May 23, 2002

Page 4

C. Does the mere existence of a clean-up call in a securitization trigger treatment as a recourse
obligation or direct credit substitute or must the clean-up call be exercised in order to trigger
this treatment?
The final rule includes clean-up calls as an example of both a “recourse” arrangement 9 and a
“direct credit substitute.”10 The rule focuses on the arrangement itself, and not the exercise of the
call. Thus, the existence, not the exercise, of a clean-up call that does not meet the requirements
laid out in the final rule will trigger treatment as a recourse obligation or a direct credit
substitute. A clean-up call can function as a credit enhancement because its existence provides
the opportunity for a banking organization (as servicer or as an affiliate of the servicer) to
provide credit support to investors by taking an action that is within the contractual terms of the
securitization documents.
IV. Other Issues
A. Does the final rule change the risk weight/conversion factor for performance standby letters
of credit?
No. “Performance standby letters of credit,” as defined in the Agencies' risk-based capital
standards,11 generally do not meet the definition of a direct credit substitute. Therefore, they are
not covered under the final rule and will still be converted at 50% and generally risk weighted at
100%.12
B. The final rule states that for an internal credit risk rating system for an asset-backed
commercial paper program to be adequate, “an internal audit procedure should periodically
verify that internal risk ratings are assigned in accordance with the banking organization’s
established criteria.”13 Does the internal audit procedure have to be performed by the internal
audit department or can it be performed by another independent entity within the organization?
The final rule does not require the internal audit of the internal credit risk rating system to be
performed by the internal audit department. Any group within the organization that is qualified
to audit the system and independent of both the group that makes the decision to extend credit to
the asset-backed commercial paper program and the groups that develop and maintain the
internal credit risk rating system may perform the internal audit of the system.

9

12 CFR part 3, appendix A, § 4(a)(11)(vii) (OCC); 12 CFR parts 208 and 225, appendix A, § III.B.3.a.x.7 (Board);
12 CFR part 325, appendix A, § II.B.5(a)(11)(vii) (FDIC); 12 CFR § 567.1 (OTS).
10
12 CFR part 3, appendix A, § 4(a)(4)(vii) (OCC); 12 CFR parts 208 and 225, appendix A, § III.B.3.a.iii.7 (Board);
12 CFR part 325, appendix A, § II.B.5(a)(4)(vii) (FDIC); 12 CFR § 567.1 (OTS).
11
See 12 CFR part 3, appendix A § 3(b)(2) (OCC); 12 CFR parts 208 and 225, appendix A, § III.D.2 (FRB); 12
CFR part 325, appendix A, § II.D.2 (FDIC); 12 CFR § 567.1 (OTS).
12
12 CFR part 3, appendix A, section 3(b)(2)(i) (OCC). See also 12 CFR Parts 208 and 225, appendix A, § III.D.2.
(Board); 12 CFR part 325, Appendix A, § II.D.2 (FDIC); 12 CFR § 567.6(a)(2)(ii) (OTS).
13
12 CFR part 3, appendix A, § 4(g)(1)(vii) (OCC); 12 CFR parts 208 and 225, appendix A, § III.B.3.f.i.7 (Board);
12 CFR part 325, Appendix A, § II.B.5(g)(1)(vii) (FDIC); 12 CFR § 567.6(b)(4)(ii)(A)(7) (OTS).

Date:

May 23, 2002

Page 5

C. How is the capital treatment described in the Synthetic Collateralized Loan Obligations
guidance published by the OCC (OCC 99-43) and the Board (SR 99-32) in November 1999
affected by the final rule?
The preamble to the final rule addresses the modification of the treatment of credit derivative
transactions outlined in the November 1999 guidance. “With the issuance of this final rule, the
agencies reaffirm the validity of the structural and risk-management requirements of the
December [sic] 1999 guidance on synthetic securitizations issued by the Board and the OCC,
while modifying the risk-based capital treatment detailed therein with the treatment presented in
this final rule.” 66 Fed. Reg. 56914, 59622. The following detailed information will clarify the
risk-based capital treatment appropriate to the credit derivative transactions presented in the
November 1999 guidance.
The joint OCC and Board guidance on synthetic collateralized loan obligations discussed the
risk-based capital treatment of three specific types of synthetic securitization transactions,
subject to the sponsoring banking organization’s compliance with minimum risk management
requirements. The objective of these capital interpretations was to recognize the effective
transference of the economic risk of loss in these synthetic securitization transactions. As
discussed more fully below, the risk-based capital treatment of the first two structures described
in the November 1999 guidance remains largely unchanged. The qualification requirements for
the second structure (Bistro-type transactions) have been modified to eliminate the restriction on
the size of the retained first loss position. The final rule has the greatest effect on the risk-based
capital treatment of the third structure. As indicated in the preamble to the final rule, the risk
management requirements contained in the joint OCC and Board guidance are still in force.
In the first structure the sponsoring banking organization, through a synthetic collateralized loan
obligation (CLO), hedges the entire notional amount of a reference asset portfolio. The credit
protection is obtained through the issuance of credit-linked notes (CLNs), the proceeds of which
fully collateralize a portfolio of the banking organization’s loans. The zero risk-weight on the
cash-collateralized loans is not affected by the final rule.
In structure 2 (Bistro-type) transactions, the sponsoring banking organization hedges a portion of
the reference portfolio and retains a high quality senior risk position that absorbs only those
credit losses in excess of the junior loss positions. There is no change in the capital treatment for
this type of transaction under the final rule: dollar-for-dollar capital on the retained first loss
piece14 and a 20 percent risk weight on the retained senior piece if it is senior to AAA-rated
credit-linked notes (CLNs). The final rule expressly permits “inferred” ratings.15 To obtain that
capital treatment, it is no longer necessary to limit the retained first loss piece to “a small cash
14

12 CFR part 3, appendix A, § 4(f)(3) (OCC); 12 CFR parts 208 and 225, Appendix A, § III.B.3.e (Board); 12 CFR
part 325, appendix A, § II.B.5(f)(3) (FDIC). If the banking organization can obtain a rating of BB or better on the
first loss position, and the first loss position is not a credit-enhancing interest-only strip (as defined in the final rule),
then the banking organization may be able to apply a more favorable risk weight to the first loss position. See 12
CFR part 3, appendix A, § 4(d); 12 CFR parts 208 and 225, Appendix A, § III.B.3.c (Board); 12 CFR part 325,
appendix A, § II.B.5(d) (FDIC).
15
12 CFR part 3, appendix A, § 4(e) (OCC); 12 CFR parts 208 and 225, Appendix A, § III.B.3.d (Board); 12 CFR
part 325, appendix A, § II.B.5(e) (FDIC).

Date:

May 23, 2002

Page 6

reserve, sufficient to cover expected losses” as specified in the guidance. A banking organization
entering into a structure 2-type transaction still must satisfy the risk management conditions
contained in the annex of the guidance in order to receive the risk-based capital treatment
described above.
In a structure 3 transaction, the sponsoring banking organization retains a subordinated position
that absorbs first losses in a reference portfolio. The joint OCC and Board guidance identified
three distinguishing features of a structure 3-type transaction: (1) the sponsoring banking
organization retains a first loss position greater than expected loss, (2) an intermediary OECD
bank establishes a special purpose entity (SPE) to issue the AAA-rated CLNs, and (3) the
sponsoring banking organization purchased protection on both the second loss and the senior
positions from the intermediary bank. Under the joint guidance, the capital treatment was the
larger of two alternative approaches: (1) dollar-for-dollar capital on the retained first loss piece
or (2) application of the risk weight of the underlying exposures to the face amount of the first
loss piece, plus zero percent risk weight on the collateralized mezzanine position, and plus 20
percent risk weight on the retained senior position protected by a credit derivative from the
intermediary bank. The final rule changes this capital treatment.
Under the final rule, a sponsoring banking organization entering into a structure 3-type
transaction would hold dollar-for-dollar capital on the retained first loss piece.16 The senior loss
position would receive a 20 percent risk weight when protected by a credit derivative from an
OECD bank or from certain qualifying securities firms.17 The mezzanine, second-loss position
that is collateralized by U.S. Treasury securities would continue to receive a zero percent risk
weight.
This interpretation, particularly the lifting of the restriction on the size of the retained first loss
piece on structure 2 transactions, removes the main structural distinction between structure 2 and
structure 3 transactions. (The other structural difference, the issuance of the CLNs by an SPE
established by an intermediary bank, does not affect the credit protection obtained by the
sponsoring banking organization.) In both structures, the second loss position is collateralized
by U.S. Treasury securities. Thus, a sponsoring banking organization’s credit risk exposure for
the first and second loss positions is virtually identical whether it employs structure 2, and forms
an SPE directly to issue the CLNs, or structure 3, and purchases credit protection from an
intermediary that forms the SPE to issue the CLNs. If the sponsoring banking organization
satisfies all of the risk management conditions contained in the annex of the joint agency
guidance, a structure 3 transaction may be classified as a structure 2 transaction and qualify for
the risk-based capital treatment for such transactions. In other words, the sponsoring banking
organization no longer is required to purchase protection on the senior loss position in order to
assign a 20 percent risk weight to that position. Rather, it can assign a 20 percent risk weight
based on the inferred rating of the subordinate credit linked notes. However, if the sponsoring
banking organization does not meet the risk management conditions, it must purchase credit
16

See note 13, supra.
See 67 Fed. Reg. 16971, 16976 (referencing OCC regulatory text section 3(a)(2)(xiii) of 12 CFR part 3, appendix
A that describes those securities firms that would qualify for a 20% risk weight under the final rule revising the risk
weights for certain claims on securities firms).

17

Date:

May 23, 2002

Page 7

protection from an OECD bank or securities firm that qualifies for a 20 percent risk weight,
before assigning a 20 percent risk weight to the retained senior position.18
Additionally, because the zero percent risk weight on the second loss position is due to the U.S.
Treasury securities collateral, not the type of intermediary that establishes the SPV, the
sponsoring banking organization could use a non-depository institution as an intermediary.
However, because synthetic transactions expose banking organizations to risk other than credit
risk, the intermediary should be of high quality, e.g. at least investment grade.
The Agencies plan to revise the Risk Based Capital Treatment of Synthetic Collateralized Loan
Obligations guidance to reflect the changes described above.

18

If the sponsoring bank decides to use an intermediary that is not an OECD bank or a securities firm that qualifies
for a 20% risk weight, the sponsoring bank must assign a 100% risk weight to the senior position.

Date:

May 23, 2002

Page 8


Federal Reserve Bank of St. Louis, One Federal Reserve Bank Plaza, St. Louis, MO 63102