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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.
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.
2
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 § 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 (202/8745700); or Steve Jackson, National Bank Examiner, Treasury and Market Risk (202/8745070).
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
3
(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 (202/9066465), 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
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
4
III.
IV.
V.
VI.
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
Regulatory Flexibility Act
Paperwork Reduction Act
Executive Order 12866
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
• Treat recourse obligations and direct credit substitutes consistently for
risk-based capital purposes; and
• Vary the capital requirements for traded and non-traded2 positions in securitized
transactions according to their relative risk exposure, using credit ratings from nationallyrecognized statistical rating organizations3 (rating agencies) to measure the level of risk.
1
The OTS is adding a definition of "standby-type letter of credit" to be consistent with
the other agencies.
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).
5
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.
6
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.
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, overcollateralization, or other forms of selfenhancement. 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 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).
4
As used in this proposal, the terms "credit enhancement" and "enhancement" refer to
both recourse arrangements and direct credit substitutes.
7
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, Pub. L. 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, Pub. L. 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
8
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 onbalance 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.
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 onbalance 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
5
Current rules also provide for special treatment of sales of small business loan
obligations with recourse. See 12 U.S.C. 1835.
9
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 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
10
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.
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.
6
The OTS has followed GAAP since 1989 for reporting purposes and for
computation of the capital leverage ratio.
11
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 riskbased 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
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."
12
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 nonperforming 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
13
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
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
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.
14
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
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.
15
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
16
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.
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).
17
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,
18
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 thirdparty 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 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.
19
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
• 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
If a recourse obligation, direct credit substitute, or senior security receives
different ratings from the rating agencies, the highest ratings would determine the capital
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.
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.
20
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
12
See T. McGuire, Moody's Investors Service, Ratings in Regulation: A Petition to
the Gorillas (1995).
21
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.
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-based approach for non-traded positions.
(Question 2) How could the agencies prudently and effectively apply the multilevel 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 nontraded 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.”
22
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.
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 “thinstrip” 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
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.
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,
23
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 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.
24
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 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
25
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 thinstrip 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?
26
[INSERT FIGURE 1 AND FIGURE 2 HERE]
27
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.
28
Table 1 -- A-B-C Structure
(Underlying Assets -- $100 million of
Non-Mortgage Loans)
Current Capital
Requirement for
Banks
($ mil)
Face Value
Approach
($ mil)
Modified Gross-Up
Approach
($ mil)
Position
Size
($ mil)
A
$80
AAA
$6.40
$6.40
$1.28
$1.28
B
9
BBB
7.12
0.72
0.72
3.56
C
11
Unrated
8.00
8.00
8.00
8.00
21.52
15.12
10.00
12.84
Total Capital:
Credit
Rating
Current Capital
Requirement for
Thrifts
($ mil)
29
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.
30
Table 2 -- A-B Structure
(Underlying Assets -- $100 million of
Non-Mortgage Loans)
Current Capital
Requirement for
Thrifts
($ mil)
Current Capital
Requirement for
Banks
($ mil)
Face Value
Approach
($ mil)
Modified Gross-Up
Approach
($ mil)
Position
Size
($ mil)
Credit
Rating
A
$80
A
$6.40
$6.40
$6.40
$3.20
B
20
Unrated
8.00
8.00
8.00
8.00
14.40
14.40
14.40
11.20
Total Capital:
31
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 bottomlevel class and sells the other three 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.
32
Table 3 -- Multi-Tranche Structure
(Underlying Assets -- $100 million of
50 percent Risk-Weight Mortgage Loans)
Current Capital
Requirement for
Thrifts
($ mil)
Current Capital
Requirement for
Banks
($ mil)
Face Value
Approach
($ mil)
Modified Gross-Up
Approach
($ mil)
Position
Size
($ mil)
Credit
Rating
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
0.75
Unrated
0.750
0.750
0.750
0.750
4.552
4.810
2.482
4.552
Total Capital:
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.
33
Table 4 -- Multi-Tranche Structure
(Underlying Assets -- $100 million of
Non-Mortgage Loans)
Current Capital
Requirement for
Thrifts
($ mil)
Current Capital
Requirement for
Banks
($ mil)
Face Value
Approach
($ mil)
Modified-GrossUp Approach
($mil)
Position
Size
($ mil)
Credit Rating
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
42.40
13.52
9.04
20.72
Total Capital:
34
E.
Alternative Approaches
1.
Ratings Benchmark Approach
a.
Description of Approach
Because of some concerns with the use of the ratings-based approach for nontraded 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 nontraded 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 ratingsbased 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 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
35
that fail to satisfy the applicable benchmarks would be grossed-up.16
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.
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 ratingsbased 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.
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.
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 form the
underlying assets, plus a normal servicing fee rate. The excess spread serves as a cushion
to cover potential losses on the underlying loans.
36
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.
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 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. Nontraded 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.
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.
37
f.
Benchmarks
Following are draft initial ratings benchmarks for securitizations backed by
residential mortgages, credit cards, automobile loans, trade receivables, and commercial
real estate.
38
Residential Mortgage-Backed Securities
Pool Type1,2
“Rating Benchmark” Prior Credit Enhancement
Required for “A” Rating
30-year loans
1.6 percent
15-year loans
0.8 percent
Adjustable Rate Mortgages
(ARMs) (1,5), (2,6)
2.4 percent
Hybrid loans (fixed-tovariable)
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 0.53,4.
1
2
3
4
For positions that represent less than 10 percent of the size of the underlying pool of loans, add 20 percent to the enhancement level.
For closed-end second mortgage securities, determine the LTV ratio of the loans in the security and apply the enhancement requirements for the unde
collateral. In addition, change the 15-year enhancement requirement to 1.6 percent due to increased risk of security.
The reduction in the multiplier over time reflects the reduced risk of the mortgage portfolio due to seasoning.
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.
39
Asset-Backed Securities
Pool Type1
“Rating Benchmark” Prior Credit Enhancement
Required for “A” Rating
Credit Cards2
The higher of 6 percent or 1.2 times lagged charge-off rate3.
Enhancement has ac
Auto Loans
Prime (A type)
Sub-prime (B, C, and D types)
7.0 percent
The higher of 15.0 percent or 3 times net expected loss rate4.
Sellers of automobil
years of historical in
Enhancement has ac
Trade Receivables
12.0 percent per loan pool5 (if all sellers of trade receivables are rated 1 or 2)
18.0 percent per loan pool5 (if any seller of trade receivables is rated 3 or 4 and no lower
than 4)
Pools may not have
percent of pool amo
Based on Federal Re
trade receivables, ea
and 4.
The above enhancements will remain fixed as a percentage of outstanding
principal, with a floor of 3 percent of original principal.
1
2
3
4
5
For credit cards and
randomly selected a
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.
Credit cards include home equity lines of credit that are similar to credit card loans.
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
Net expected loss rate is the monthly average of last quarter’s gross default amount netted against recoveries, multiplied by twelve, then divided by th
balance for the last quarter.
Overcollateralization amount would count toward credit enhancement.
40
Commercial Mortgage-Backed Securities
Pool Type1
“Rating Benchmark” Prior Credit Enhancement
Required for “A” Rating
Office
26.0 percent
Debt-service
Regional Mall
10.0 percent
Debt-service
Industrial/Anchored Retail
13.0 percent
Debt-service
Multifamily
17.0 percent
Debt-service
The above enhancements are for pools of loans with loan-to-value ratios less than or equal to 70
percent. For pools of loans with greater than 70 percent loan-to-value ratio, multiply the above
enhancements by 1.5.
For each type
-- No borrow
5 percent o
-- The amort
not exceed
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 principal2.
1
2
For positions that represent less than 10 percent of the underlying pool of loans, add 20 percent to the credit enhancement level.
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
41
g.
Examples
To determine the dollar amount of prior credit enhancement required for a nontraded 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
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.
20
The reduction in the required credit enhancement amount over time is due to the
reduced credit risk of seasoned mortgage loan pools.
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.
42
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 fullygrossed-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 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.
43
(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
44
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 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
45
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 grossup 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?
46
(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
47
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 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
48
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.
49
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
*****
50
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 *
*
*
(ii) *
*
* 17 *
*
*
*
*
*
(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;
16
Participations in performance-based standby letters of credit are treated in
accordance with section 3(d) of this appendix A.
17
Participations in commitments are treated in accordance with section 3(d) of this
appendix A.
51
(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
52
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 assetor 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
53
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 appendix A if it has been rated investment grade by two nationallyrecognized 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
54
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
55
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]
*****
Date: October 22, 1997
Eugene A. Ludwig
Comptroller of the Currency
56
Federal Reserve System
12 CFR Chapter II
Authority and Issuance
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, 1831p1,1831 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;
57
(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 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
58
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 assetor 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
59
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
60
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 participation23 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 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
61
(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
(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
category is appropriate to the obligor, guarantor, or collateral.
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.
62
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 riskbased 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.
*****
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:
*****
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 privatelyissued 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.
63
III. * * *
C. * * *
3. * * * 39 * * *
*****
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,
39a
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.
39b
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 riskbased 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.
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 localcurrency 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
64
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.
(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 OECDbased 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 riskweighted 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
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.
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
65
factors for various types of off-balance-sheet items.
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 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.
(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.
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.
45
Forward forward deposits accepted are treated as interest rate contracts.
66
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
67
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 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;
68
(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 assetor 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,
69
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 assetor 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.
70
[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 participation26 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
(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.
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.
71
(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
(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 organizations'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 onbalance 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
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.
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
72
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.
*****
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
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 privatelyissued 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.
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.
73
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.
(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 OECDbased 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
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.
74
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.
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 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 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.
(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.
*****
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.
48
Forward forward deposits accepted are treated as interest rate contracts.
75
By order of the Board of Governors of the Federal Reserve System, October 21, 1997.
William W. Wiles
Secretary of the Board
76
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. 102242, 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;
77
(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
78
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
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
79
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,
80
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 riskbased 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 participation14 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
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.
81
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
(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
(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 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
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.
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.
82
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 mortgagebacked 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.
83
(e) Other stripped mortgage-backed securities. All other stripped mortgagebacked 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 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
84
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
(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
(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
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 localcurrency liabilities held by subsidiary depository institutions.
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.
85
(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
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 riskweighted 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
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 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.
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.
40
Forward forward deposits accepted are treated as interest rate contracts.
86
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
87
*****
[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 OffBalance 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
(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.
*****
88
By order of the Board of Directors.
Dated at Washington, D.C., this 16th day of September, 1997.
Federal Deposit Insurance Corporation
Robert E. Feldman
Executive Secretary
89
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) the phrase “§567.6(a)(vi)” and adding in lieu thereof the
phrase “§567.6(a)(1)(vi),” and by revising paragraph (kk) to read as follows:
§ 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 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 by adding
paragraph (b) to read as follows:
90
§ 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 offbalance sheet items (as computed under paragraph (a)(2) of this section), plus riskweighted 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 § 567.5 are not included in calculating riskweighted 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 mortgagebacked 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
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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 mortgagebacked 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
92
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.
(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 § 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 § 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
93
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 § 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 apply 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 mortgagerelated 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
94
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 §§ 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;
95
(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 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
96
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 assetor 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
BILLING CODES
4810-33-P
6210-01-P
6714-01-P
6720-01-P