Risk-Based Capital Standards; Recourse and Direct Credit Substitutes

[Federal Register Volume 62, Number 214 (Wednesday, November 5, 1997)]

[Proposed Rules]

[Pages 59944-59976]

From the Federal Register Online via the Government Publishing Office [www.gpo.gov]

[FR Doc No: 97-28828]

[[Page 59943]]

_______________________________________________________________________

Part II

Department of the Treasury

Office of the Comptroller of the Currency

12 CFR Part 3

Federal Reserve System

12 CFR Parts 208 and 225

Federal Deposit Insurance Corporation

12 CFR Part 325

Department of the Treasury

Office of Thrift Supervision

12 CFR Part 567

_______________________________________________________________________

Risk-Based Capital Standards; Recourse and Direct Credit Substitutes;

Proposed Rule

Federal Register / Vol. 62, No. 214 / Wednesday, November 5, 1997 /

Proposed Rules

[[Page 59944]]

DEPARTMENT OF THE TREASURY

Office of the Comptroller of the Currency

12 CFR Part 3

[Docket No. 97-22]

RIN 1557-AB14

FEDERAL RESERVE SYSTEM

12 CFR Parts 208 and 225

[Regulations H and Y; Docket No. R-0985]

FEDERAL DEPOSIT INSURANCE CORPORATION

12 CFR Part 325

RIN 3064-AB31

DEPARTMENT OF THE TREASURY

Office of Thrift Supervision

12 CFR Part 567

[Docket No. 97-86]

RIN 1550-AB11

Risk-Based Capital Standards; Recourse and Direct Credit

Substitutes

AGENCIES: Office of the Comptroller of the Currency, Treasury; Board of

Governors of the Federal Reserve System; Federal Deposit Insurance

Corporation; and Office of Thrift Supervision, Treasury.

ACTION: Joint notice of proposed rulemaking.

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SUMMARY: The Office of the Comptroller of the Currency (OCC), Board of

Governors of the Federal Reserve System (Board), Federal Deposit

Insurance Corporation (FDIC), and Office of Thrift Supervision (OTS),

(collectively, the agencies) are proposing revisions to their risk-

based capital standards to address the regulatory capital treatment of

recourse obligations and direct credit substitutes that expose banks,

bank holding companies, and thrifts (collectively, banking

organizations) to credit risk. The proposal would treat direct credit

substitutes and recourse obligations consistently and would use credit

ratings and possibly certain other alternative approaches to match the

risk-based capital assessment more closely to a banking organization's

relative risk of loss in asset securitizations.

The agencies intend that any final rules adopted in connection with

this proposal that result in increased risk-based capital requirements

for banking organizations apply only to transactions consummated after

the effective date of the final rules.

DATES: Comments must be received on or before February 3, 1998.

ADDRESSES: Comments should be directed to:

OCC: Written comments may be submitted electronically to

[email protected] or by mail to Docket No. 97-22,

Communications Division, Third Floor, Office of the Comptroller of the

Currency, 250 E Street, SW., Washington, DC 20219. Comments will be

available for inspection and photocopying at that address.

Board: Comments, which should refer to Docket No. R-0985, may be

mailed to the Board of Governors of the Federal Reserve System, 20th

Street and Constitution Avenue, NW., Washington, DC 20551, to the

attention of Mr. William Wiles, Secretary. Comments addressed to the

attention of Mr. Wiles may be delivered to the Board's mail room

between 8:45 a.m. and 5:15 p.m., and to the security control room

outside of those hours. Both the mail room and the security control

room are accessible from the courtyard entrance on 20th Street between

Constitution Avenue and C Street, NW. Comments may be inspected in Room

MP500 between 9 a.m. and 5 p.m. weekdays, except as provided in

Sec. 261.8 of the FRB's Rules Regarding Availability of Information, 12

CFR 261.8.

FDIC: Written comments should be addressed to Robert E. Feldman,

Executive Secretary, Attention: Comments/OES, Federal Deposit Insurance

Corporation, 550 17th Street, N.W., Washington, D.C. 20429. Comments

may be hand delivered to the guard station at the rear of the 550 17th

Street Building (located on F Street), on business days between 7:00

a.m. and 5:00 p.m. (Fax number: (202) 898-3838; Internet address:

[email protected]). 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:

[email protected]. Those commenting by e-mail should include

their name and telephone number. Comments will be available for

inspection at 1700 G Street, N.W., from 9:00 to 4:00 p.m. on business

days.

FOR FURTHER INFORMATION CONTACT: OCC: David Thede, Senior Attorney,

Securities and Corporate Practices Division (202/874-5210); Dennis

Glennon, Financial Economist, Risk Analysis Division (202/874-5700); or

Steve Jackson, National Bank Examiner, Treasury and Market Risk (202/

874-5070).

Board: Thomas R. Boemio, Senior Supervisory Financial Analyst (202/

452-2982); or Norah Barger, Assistant Director (202/452-2402), Division

of Banking Supervision and Regulation. For the hearing impaired only,

Telecommunication Device for the Deaf (TDD), Diane Jenkins (202/452-

3544), Board of Governors of the Federal Reserve System, 20th and C

Streets, NW, Washington, DC 20551.

FDIC: Robert F. Storch, Chief, Accounting Section, Division of

Supervision, (202/898-8906), or Jamey G. Basham, Counsel, Legal

Division (202/898-7265).

OTS: John F. Connolly, Senior Program Manager for Capital Policy

(202/906-6465), Supervision Policy; Michael D. Solomon, Senior Policy

Advisor (202/906-5654), Supervision Policy; Fred Phillips-Patrick,

Senior Financial Economist (202/906-7295), Research and Analysis;

Robert Kazdin, Senior Project Manager (202/906-5759), Research and

Analysis; Karen Osterloh, Assistant Chief Counsel (202/906-6639),

Regulation and Legislation Division, Office of Thrift Supervision, 1700

G Street, N.W., Washington, D.C. 20552.

SUPPLEMENTARY INFORMATION:

Table of Contents

I. Introduction and Background

A. Overview

B. Purpose and Effect

C. Background

1. Recourse and Direct Credit Substitutes

2. Prior History

D. Current Risk-based Capital Treatment of Recourse and Direct

Credit Substitutes

1. Recourse

2. Direct Credit Substitutes

3. Problems with Existing Risk-based Capital Treatments of

Recourse Arrangements and Direct Credit Substitutes

E. GAAP Accounting Treatment of Recourse Arrangements

II. Notice of Proposed Rulemaking

A. Definitions

1. Recourse

2. Direct Credit Substitute

3. Risks Other than Credit Risks

4. Implicit Recourse

5. Subordinated Interests in Loans or Pools of Loans

[[Page 59945]]

6. Second Mortgages

7. Representations and Warranties

8. Loan Servicing Arrangements

9. Spread Accounts and Overcollateralization

B. Treatment of Direct Credit Substitutes

C. Multi-level Ratings-based Approach

1. 1994 Notice

2. Effect of Ratings Downgrades

3. Non-traded Positions

D. Face Value and Modified Gross-up Alternatives for Investment

Grade Positions Below the Highest Investment Grade Rating

1. Description of Approaches

2. Examples of Face Value and Modified Gross-up Approaches

E. Alternative Approaches

1. Ratings Benchmark Approach

2. Internal Information Approaches

a. Historical Loss Approach

b. Bank Model Approach

III. Regulatory Flexibility Act

IV. Paperwork Reduction Act

V. Executive Order 12866

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

I. Introduction and Background

A. Overview

The agencies are proposing to amend their risk-based capital

standards to clarify and change the treatment of certain recourse

obligations, direct credit substitutes, and securitized transactions

that expose banking organizations to credit risk.

This proposal would amend the agencies' risk-based capital

standards to:

Define ``recourse'' and revise the definition of ``direct

credit substitute''; 1

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\1\ The OTS is adding a definition of ``standby-type letter of

credit'' to be consistent with the other agencies.

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Treat recourse obligations and direct credit substitutes

consistently for risk-based capital purposes; and

Vary the capital requirements for traded and non-traded

2 positions in securitized transactions according to their

relative risk exposure, using credit ratings from nationally-recognized

statistical rating organizations 3 (rating agencies) to

measure the level of risk.

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\2\ See section II.C.3 of this preamble for a discussion of the

distinction between ``traded'' and ``non-traded'' positions.

\3\ ``Nationally recognized statistical rating organization''

means an entity recognized by the Division of Market Regulation of

the Securities and Exchange Commission as a nationally recognized

statistical rating organization for various purposes, including the

capital rules for broker-dealers. See SEC Rule 15c3-1(c)(2)(vi)(E),

(F) and (H) (17 CFR 240.15c3-1(c)(2)(vi)(E), (F), and (H).

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Additionally, this proposal discusses and requests comment on two

possible alternatives to the use of credit ratings for non-traded

positions in securitized transactions, either or both of which may be

adopted, in whole or in part, in the final rule. These alternatives

would:

Use criteria developed by the agencies, based on the

criteria of the rating agencies, to determine the capital requirements;

or

Permit institutions to use historical loss information to

determine the capital requirement for direct credit substitutes and

recourse obligations.

The agencies request comment on all aspects of this proposal.

B. Purpose and Effect

Implementation of all aspects of this proposal would result in more

consistent treatment of recourse obligations and similar transactions

among the agencies, more consistent risk-based capital treatment for

transactions involving similar risk, and capital requirements that more

closely reflect a banking organization's relative exposure to credit

risk.

The agencies intend that any final rules adopted in connection with

this proposal that result in increased risk-based capital requirements

for banking organizations apply only to transactions that are

consummated after the effective date of those final rules. The agencies

intend that any final rules adopted in connection with this proposal

that result in reduced risk-based capital requirements for banking

organizations apply to all transactions outstanding as of the effective

date of those final rules and to all subsequent transactions. Because

some ongoing securitization conduits may need additional time to adapt

to any new capital treatments, the agencies intend to permit asset

securitizations with no fixed term, e.g., asset-backed commercial paper

conduits, to apply the existing capital rules for up to two years after

the effective date of any final rule.

C. Background

1. Recourse and Direct Credit Substitutes

Asset securitization is the process by which loans and other

receivables are pooled, reconstituted into one or more classes or

positions, and then sold. Securitization provides an efficient

mechanism for institutions to buy and sell loan assets and thereby to

make them more liquid.

Securitizations typically carve up the risk of credit losses from

the underlying assets and distribute it to different parties. The

``first dollar'' loss or subordinate position is first to absorb credit

losses; the ``senior'' investor position is last; and there may be one

or more loss positions in between (``second dollar'' loss positions).

Each loss position functions as a credit enhancement for the more

senior loss positions in the structure.

For residential mortgages sold through certain Federally-sponsored

mortgage programs, a Federal government agency or Federally-sponsored

agency guarantees the securities sold to investors. However, many of

today's asset securitization programs involve nonmortgage assets or are

not supported in any way by the Federal government or a Federally-

sponsored agency. Sellers of these privately securitized assets

therefore often provide other forms of credit enhancement--first and

second dollar loss positions--to reduce investors' risk of credit loss.

Sellers may provide this credit enhancement themselves through

recourse arrangements. For purposes of this proposal, ``recourse''

refers to any risk of credit loss that an institution retains in

connection with the transfer of its assets. While banking organizations

have long provided recourse in connection with sales of whole loans or

loan participations, recourse arrangements today are frequently

associated with asset securitization programs.

Sellers may also arrange for a third party to provide credit

enhancement in an asset securitization. If the third-party enhancement

is provided by another banking organization, that organization assumes

some portion of the assets' credit risk. For purposes of this proposal,

all forms of third-party enhancements, i.e., all arrangements in which

an institution assumes risk of credit loss from third-party assets or

other claims that it has not transferred, are referred to as ``direct

credit substitutes.'' 4 The economic substance of an

institution's risk of credit loss from providing a direct credit

substitute can be identical to its risk of credit loss from

transferring an asset with recourse.

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\4\ As used in this proposal, the terms ``credit enhancement''

and ``enhancement'' refer to both recourse arrangements and direct

credit substitutes.

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Depending on the type of securitization transaction, a portion of

the total credit enhancement may also be provided internally, as part

of the securitization structure, through the use of spread accounts,

overcollaterali-

zation, or other forms of self-enhancement. Many asset securitizations

use a combination of internal enhancement, recourse, and third-party

enhancement to protect investors from risk of credit loss.

2. Prior History

On June 29, 1990, the Federal Financial Institutions Examination

Council (FFIEC) published a request for comment on recourse

arrangements. See

[[Page 59946]]

55 FR 26766 (June 29, 1990). The publication announced the agencies'

intent to review the regulatory capital, reporting, and lending limit

treatment of assets transferred with recourse and similar transactions,

and set out a broad range of issues for public comment. The FFIEC

received approximately 150 comment letters. The FFIEC then narrowed the

scope of the review to the reporting and capital treatment of recourse

arrangements and direct credit substitutes that expose banking

organizations to credit-related risks. The OTS implemented some of the

FFIEC's proposals (including the definition of recourse) on July 29,

1992 (57 FR 33432).

In July 1992, after receiving preliminary recommendations from an

interagency staff working group, the FFIEC directed the working group

to carry out a study of the likely impact of those recommendations on

banking organizations, financial markets, and other affected parties.

As part of that study, the working group held a series of meetings with

representatives from 13 organizations active in the securitization and

credit enhancement markets. Summaries of the information provided to

the working group and a copy of the working group's letter sent to

participants prior to the meetings are in the FFIEC's public file on

recourse arrangements and are available for public inspection and

photocopying. Additional material provided to the agencies from

financial institutions and others since these meetings has also been

placed in the FFIEC's public file. The FFIEC's offices are located at

2100 Pennsylvania Avenue, NW., Suite 200, Washington, DC 20037.

On May 25, 1994, the agencies published a Federal Register notice

(1994 Notice) containing a proposal to reduce the capital requirement

for banks for low-level recourse transactions (transactions in which

the capital requirement would otherwise exceed an institution's maximum

contractual exposure); to treat first-loss (but not second-loss) direct

credit substitutes like recourse; and to implement definitions of

``recourse,'' ``direct credit substitute,'' and related terms. 59 FR

27116 (May 25, 1994). The 1994 Notice also contained, in an advance

notice of proposed rulemaking, a proposal to use credit ratings to

determine the capital treatment of certain recourse obligations and

direct credit substitutes. The OCC, Board, and FDIC (the Banking

Agencies) have since implemented the capital reduction for low-level

recourse transactions required by section 350 of the Riegle Community

Development and Regulatory Improvement Act, Public Law 103-325, 12

U.S.C. 4808. 60 FR 17986 (OCC, April 10, 1995), 60 FR 8177 (Board,

February 13, 1995); 60 FR 15858 (FDIC, March 28, 1995). (The OTS risk-

based capital regulation already included the low-level recourse

treatment required by 12 U.S.C. 4808. See 60 FR 45618, August 31,

1995.) The other portions of the 1994 Notice will be addressed in this

proposal.

The agencies have also implemented section 208 of the Riegle

Community Development and Regulatory Improvement Act of 1994, Public

Law 103-325, 108 Stat. 2160, 12 U.S.C. 1835, which made available an

alternative risk-based capital treatment for qualifying transfers of

small business obligations with recourse. 60 FR 45611(Board final rule,

August 31, 1995); 60 FR 45605 (FDIC interim rule, August 31, 1995); 60

FR 45617 (OTS interim rule, August 31, 1995); 60 FR 47455 (OCC interim

rule, September 13, 1995).

D. Current Risk-based Capital Treatment of Recourse and Direct Credit

Substitutes

Currently, the agencies' risk-based capital standards apply

different treatments to recourse arrangements and direct credit

substitutes. As a result, capital requirements applicable to credit

enhancements do not consistently reflect credit risk. The Banking

Agencies' current rules are also not entirely consistent with those of

the OTS.

1. Recourse

The agencies' risk-based capital guidelines prescribe a single

treatment for assets transferred with recourse regardless of whether

the transaction is reported as a financing or a sale of assets in a

bank's Consolidated Reports of Condition and Income (Call Report).

Assets transferred with any amount of recourse in a transaction

reported as a financing remain on the balance sheet. Assets transferred

with recourse in a transaction that is reported as a sale create off-

balance sheet exposures. The entire outstanding amount of the assets

sold (not just the amount of the recourse) is converted into an on-

balance sheet credit equivalent amount using a 100% credit conversion

factor, and this credit equivalent amount is risk-weighted.

5 In either case, risk-based capital is held against the

full, risk-weighted amount of the transferred assets, subject to the

low-level recourse rule which limits the maximum risk-based capital

requirement to the bank's maximum contractual obligation.

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\5\ Current rules also provide for special treatment of sales of

small business loan obligations with recourse. See 12 U.S.C. 1835.

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For leverage capital ratio purposes, if a sale with recourse is

reported as a financing, then the assets sold with recourse remain on

the selling bank's balance sheet. If a sale with recourse is reported

as a sale, the assets sold do not remain on the selling bank's balance

sheet.

2. Direct Credit Substitutes

a. Banking Agencies. Direct credit substitutes are treated

differently from recourse under the current risk-based capital

standards. Under the Banking Agencies' standards, off-balance sheet

direct credit substitutes, such as financial standby letters of credit

provided for third-party assets, carry a 100% credit conversion factor.

However, only the dollar amount of the direct credit substitute is

converted into an on-balance sheet credit equivalent so that capital is

held only against the face amount of the direct credit substitute. The

capital requirement for a recourse arrangement, in contrast, is

generally based on the full amount of the assets enhanced.

If a direct credit substitute covers less than 100% of the

potential losses on the assets enhanced, the current capital treatment

results in a lower capital charge for a direct credit substitute than

for a comparable recourse arrangement. For example, if a direct credit

substitute covers losses up to the first 20% of the assets enhanced,

then the on-balance sheet credit equivalent amount equals that 20%

amount and risk-based capital is held against only the 20% amount. In

contrast, required capital for a first-loss 20% recourse arrangement is

higher because capital is held against the full outstanding amount of

the assets enhanced.

Banking organizations are taking advantage of this anomaly, for

example, by providing first loss letters of credit to asset-backed

commercial paper conduits that lend directly to corporate customers.

This results in a significantly lower capital requirement than if the

loans were on the banking organizations' balance sheets.

Under the proposal, the definition of direct credit substitute is

expanded to include some items that already are partially reflected on

the balance sheet, such as purchased subordinated interests. Currently,

under the Banking Agencies' guidelines, these interests receive the

same capital treatment as off-balance sheet direct credit substitutes.

Purchased subordinated interests are placed in the appropriate risk-

weight category. In contrast, if a banking organization retains a

[[Page 59947]]

subordinated interest in connection with the transfer of its own

assets, this is considered recourse. As a result, the institution must

hold capital against the carrying amount of the retained subordinated

interest as well as the outstanding amount of all senior interests that

it supports.

b. OTS. The OTS risk-based capital regulation treats some forms of

direct credit substitutes (e.g., financial standby letters of credit)

in the same manner as the Banking Agencies' guidelines. However, unlike

the Banking Agencies, the OTS treats purchased subordinated interests

under its general recourse provisions (except for certain high quality

subordinated mortgage-related securities). The risk-based capital

requirement is based on the carrying amount of the subordinated

interest plus all senior interests, as though the thrift owned the full

outstanding amount of the assets enhanced.

3. Problems With Existing Risk-based Capital Treatments of Recourse

Arrangements and Direct Credit Substitutes.

The agencies are proposing changes to the risk-based capital

standards to address the following major concerns with the current

treatments of recourse and direct credit substitutes:

Different amounts of capital can be required for recourse

arrangements and direct credit substitutes that expose a banking

organization to equivalent risk of credit loss.

The capital treatment does not recognize differences in

risk associated with different loss positions in asset securitizations.

The current standards do not provide uniform definitions

of recourse, direct credit substitute, and associated terms.

E. GAAP Accounting Treatment of Recourse Arrangements

The Banking Agencies' regulatory capital treatment of asset

transfers with recourse differs from the accounting treatment of asset

transfers with recourse under generally accepted accounting principles

(GAAP). Under GAAP, an institution that transferred an asset with

recourse before January 1, 1997, must reserve in a recourse liability

account the probable expected losses under the recourse obligation and

meet certain other criteria in order to treat the asset as sold. An

institution that transfers an asset with recourse after December 31,

1996, must surrender control over the asset and receive consideration

other than a beneficial interest in the transferred asset in order to

treat the asset as sold. The institution must recognize a liability for

its recourse obligation, measuring this liability at its fair value or

by alternative means. Although the Banking Agencies have adopted GAAP

for reporting sales of assets with recourse in 1997,6 the

agencies continue to require risk-based capital in addition to the GAAP

recourse liability account for recourse obligations.

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\6\ The OTS has followed GAAP since 1989 for reporting purposes

and for computation of the capital leverage ratio.

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The agencies have considered the arguments that several commenters

(responding to the 1994 Notice) made for adopting for regulatory

capital purposes the GAAP treatment for all assets sold with recourse,

including those sold with low levels of recourse. Under such a

treatment, assets sold with recourse in accordance with GAAP would have

no capital requirement, but the GAAP recourse liability account would

provide some level of protection against losses.

One of the principal purposes of regulatory capital is to provide a

cushion against unexpected losses. In contrast, the GAAP recourse

liability account is, in effect, a specific reserve that primarily

takes into account the probable expected losses under the recourse

provision. The capital guidelines explicitly state that specific

reserves may not be included in regulatory capital.

Even though a transferring institution may reduce its exposure to

potential catastrophic losses by limiting the amount of recourse it

provides, it may still retain, in many cases, the bulk of the credit

risk inherent in the assets. For example, an institution transferring

high quality assets with a reasonably estimated expected loss rate of

one percent that retains ten percent recourse in the normal course of

business will sustain the same amount of losses it would have had the

assets not been transferred. This occurs because the amount of exposure

under the recourse provision is very high relative to the amount of

expected losses. In such transactions the transferor has not

significantly reduced its risk for purposes of assessing regulatory

capital and should continue to be assessed regulatory capital as though

the assets had not been transferred.

Further, the agencies are concerned that an institution

transferring assets with recourse might significantly underestimate its

losses under the recourse provision or the fair value of its recourse

obligation, in which case it would not establish an appropriate GAAP

recourse liability account for the exposure. If the transferor recorded

an inappropriately small liability in the GAAP recourse liability

account for a succession of asset transfers, it could accumulate large

amounts of credit risk that would be only partially reflected on the

balance sheet.

For these reasons, the agencies have not proposed to adopt for

regulatory capital purposes the GAAP treatment for assets sold with

recourse. The agencies invite additional comments on this issue.

II. Notice of Proposed Rulemaking

This proposal would amend the agencies' risk-based capital

standards as follows:

Define recourse and revise the definition of direct credit

substitute (See section II.A of this preamble);

Treat recourse obligations and direct credit substitutes

consistently for risk-based capital purposes (See section II.B of this

preamble); and

Vary the capital requirements for traded and non-traded

positions in securitized asset transactions according to their relative

risk exposure, using credit ratings from rating agencies to measure the

level of risk (See sections II.C and II.D of this preamble).

Additionally, this notice discusses and requests comment on two

possible alternatives to the use of credit ratings for non-traded

positions in securitized transactions, either or both of which may be

adopted, in whole or in part, in the final rule (See section II.E of

this preamble). These alternatives would:

Use criteria developed by the agencies, based on the

criteria of the rating agencies, to determine the capital requirements;

or

Permit institutions to use historical loss information to

determine the capital requirements for direct credit substitutes and

recourse obligations.

A. Definitions

1. Recourse

The proposal defines recourse to mean any arrangement in which an

institution retains risk of credit loss in connection with an asset

transfer, if the risk of credit loss exceeds a pro rata share of the

institution's claim on the assets. The proposed definition of recourse

is consistent with the Banking Agencies' longstanding use of this term,

and is intended to incorporate into the risk-based capital standards

existing agency practices regarding retention of risk in asset

transfers.7

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\7\ The OTS currently defines the term ``recourse'' more broadly

than the proposal to include arrangements involving credit risk that

a thrift assumes or accepts from third-party assets as well as risk

that it retains in an asset transfer. Under the proposal, as

explained below, credit risk that an institution assumes from third-

party assets would fall under the definition of ``direct credit

substitute'' rather than ``recourse.''

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[[Page 59948]]

Currently, the term ``recourse'' is not explicitly defined in the

Banking Agencies' risk-based capital guidelines. Instead, the

guidelines use the term ``sale of assets with recourse,'' which is

defined by reference to the Call Report Instructions. See Call Report

Instructions, Glossary (entry for ``Sales of Assets''). Once a

definition of recourse is adopted in the risk-based capital guidelines,

the Banking Agencies would remove the cross-reference to the Call

Report instructions from the guidelines. The OTS capital regulation

currently provides a definition of the term ``recourse,'' which would

also be replaced once a final definition of recourse is adopted.

2. Direct Credit Substitute

The proposed definition of ``direct credit substitute'' is intended

to mirror the definition of recourse. The term ``direct credit

substitute'' would refer to any arrangement in which an institution

assumes risk of credit-related losses from assets or other claims it

has not transferred, if the risk of credit loss exceeds the

institution's pro rata share of the assets or other claims. Currently,

under the Banking Agencies' guidelines, this term covers guarantees and

guarantee-type arrangements. As revised, it would also explicitly

include items such as purchased subordinated interests, agreements to

cover credit losses that arise from purchased loan servicing rights,

and subordinated extensions of credit that provide credit enhancement.

3. Risks Other than Credit Risks

A capital charge would be assessed only against arrangements that

create exposure to credit or credit-related risks. This continues the

agencies' current practice and is consistent with the risk-based

capital standards' traditional focus on credit risk. The agencies have

undertaken other initiatives to ensure that the risk-based capital

standards take interest rate risk and other non-credit related market

risks into account.

4. Implicit Recourse

The definitions cover all arrangements that are recourse or direct

credit substitutes in form or in substance. Recourse may also exist

when an institution assumes risk of loss without an explicit

contractual agreement or, if there is a contractual limit, when the

institution assumes risk of loss in amounts exceeding the limit. The

existence of implicit recourse is often a complex and fact-specific

issue, usually demonstrated by an institution's actions beyond any

contractual obligation. Actions that may constitute implicit recourse

include: (a) Providing voluntary support for a securitization by

selling assets to a trust at a discount from book value; (b) exchanging

performing for non-performing assets; or (c) other actions that result

in a significant transfer of value in response to deterioration in the

credit quality of a securitized asset pool.

To date, the agencies have taken the position that when an

institution provides implicit recourse, it should generally hold

capital in the same manner as for assets sold with recourse. However,

because of the complexity and fact-specific nature of many implicit

recourse arrangements, questions have been raised as to how much risk

the institution has effectively retained as a result of its actions and

whether a different capital treatment would be warranted in some

circumstances. To assist the agencies in assessing various types of

implicit recourse arrangements, comment is requested on the following:

(Question 1) What types of actions should be considered implicit

recourse, and how should the agencies treat these actions for

regulatory capital purposes? Should the agencies establish different

capital requirements for various types of implicit recourse

arrangements? If so, how should appropriate capital requirements be

determined for different types of implicit recourse arrangements?

Please provide relevant data to support any recommended capital

treatment.

The agencies may issue additional interpretive guidance as needed

to further clarify the circumstances in which an institution will be

considered to have provided implicit recourse.

One commenter responding to the 1994 Notice asked for clarification

that a repurchase triggered by a breach of a standard representation or

warranty (as defined below) would not be considered implicit recourse.

Such a repurchase would not constitute implicit recourse because the

repurchase is required by a contractual obligation created at the time

of the sale.

5. Subordinated Interests in Loans or Pools of Loans

The definitions of recourse and direct credit substitute explicitly

cover an institution's ownership of subordinated interests in loans or

pools of loans. This continues the Banking Agencies' longstanding

treatment of retained subordinated interests as recourse and recognizes

that purchased subordinated interests can also function as credit

enhancements. (The OTS currently treats both retained and purchased

subordinated securities as recourse obligations.) Subordinated

interests generally absorb more than their pro rata share of losses

(principal or interest) from the underlying assets in the event of

default. For example, a multi-class asset securitization may have

several classes of subordinated securities, each of which provides

credit enhancement for the more senior classes. Generally, the holder

of any class that absorbs more than its pro rata share of losses from

the total underlying assets is providing credit protection for all more

senior classes.8

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

\8\ Current OTS risk-based capital guidelines exclude certain

high-quality subordinated mortgage-related securities from treatment

as recourse arrangements due to their credit quality. Consistent

with these capital guidelines, the proposed OTS rule text includes

the face value of high-quality subordinated mortgage-related

securities in the 20% risk weight category.

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

Two commenters questioned the treatment of purchased subordinated

interests as recourse. Subordinated interests expose holders to

comparable risk regardless of whether the interests are retained or

purchased. If purchased subordinated interests were not treated as

recourse, institutions could avoid recourse treatment by swapping

retained subordinated interests with other institutions or by

purchasing subordinated interests in assets originated by a conduit.

The proposal would mitigate the effect of treating purchased

subordinated interests as recourse by reducing the capital requirement

on interests that qualify under the multi-level approach described in

sections II.C, D, and E of this preamble.

6. Second Mortgages

Second mortgages or home equity loans would generally not be

considered recourse or direct credit substitutes, unless they actually

function as credit enhancements by facilitating the sale of the first

mortgage. For example, this may occur if a lender has a program of

originating first and second mortgages contemporaneously on the same

property and then selling the first mortgage and retaining the second.

In such a program, a second mortgage can function as a substitute for a

recourse arrangement because it is intended that the holder of the

second mortgage will absorb losses before the holder of the first

mortgage does if the borrower fails to make all payments due on both

loans.

The preamble to the 1994 Notice stated that a second mortgage

originated

[[Page 59949]]

contemporaneously with the first mortgage would be presumed to be

recourse. Many commenters criticized this position as overly broad. The

agencies agree and do not propose to retain the presumption.

However, the agencies expect institutions to follow prudent

underwriting practices in making combined extensions of credit (i.e., a

contemporaneous first and second mortgage loan) or other second

mortgages to a single borrower. If an institution does not apply

prudent underwriting standards in making combined loans, the agencies

will consider this practice in determining whether the institution is

using such mortgages to retain recourse and generally in evaluating the

soundness of the institution's underwriting standards and in

determining the adequacy of the institution's capital.

7. Representations and Warranties

When a banking organization transfers assets, including servicing

rights, it customarily makes representations and warranties concerning

those assets. When a banking organization purchases loan servicing

rights, it may also assume representations and warranties made by the

seller or a prior servicer. These representations and warranties give

certain rights to other parties and impose obligations upon the seller

or servicer of the assets. The definitions in this proposal would treat

as recourse or direct credit substitutes any representations or

warranties that create exposure to default risk or any other form of

open-ended, credit-related risk from the assets that is not

controllable by the seller or servicer. This reflects the agencies'

current practice with respect to recourse arising out of

representations and warranties, and explicitly recognizes that a

servicer with purchased loan servicing rights can also take on risk

through servicer representations and warranties.

The agencies recognize, however, that the market requires asset

transferors and servicers to make certain representations and

warranties, and that most of these present only normal operational

risk. Currently, the agencies have no formal definitions distinguishing

between these types of standard representations and warranties and

those that create recourse or direct credit substitutes. The proposal

therefore defines the term ``standard representations and warranties''

and provides that seller or servicer representations or warranties that

meet this definition are not considered to be recourse obligations or

direct credit substitutes.

Under the proposal, ``standard representations and warranties'' are

those that refer to an existing state of facts that the seller or

servicer can either control or verify with reasonable due diligence at

the time the assets are sold or the servicing rights are transferred.

These representations and warranties will not be considered recourse or

direct credit substitutes, provided that the seller or servicer

performs due diligence prior to the transfer of the assets or servicing

rights to ensure that it has a reasonable basis for making the

representation or warranty. The term ``standard representations and

warranties'' also covers contractual provisions that permit the return

of transferred assets in the event of fraud or documentation

deficiencies, (i.e., if the assets are not what the seller represented

them to be), consistent with the current Call Report Instructions

governing the reporting of asset transfers. After a final definition of

``standard representations and warranties'' is adopted for the risk-

based capital standards, the Banking Agencies would recommend to the

FFIEC that the Call Report Instructions be changed to conform to the

capital guidelines and the OTS would similarly amend the instructions

for the Thrift Financial Report (TFR).

Examples of ``standard representations and warranties'' include

seller representations that the transferred assets are current (i.e.,

not past due) at the time of sale; that the assets meet specific,

agreed-upon credit standards at the time of sale; or that the assets

are free and clear of any liens (provided that the seller has exercised

due diligence to verify these facts). An example of a nonstandard

representation and warranty is an agreement by the seller to buy back

any assets that become more than 30 days past due or default within a

designated time period after the sale. Another example of a nonstandard

representation and warranty is a representation that all properties

underlying a pool of transferred mortgages are free of environmental

hazards. This representation is not verifiable by the seller or

servicer with reasonable due diligence because it is not possible to

absolutely verify that a property is, in fact, free of all

environmental hazards. Such an open-ended guarantee against the risk

that unknown but currently existing hazards might be discovered in the

future would be considered recourse or a direct credit substitute.

However, a seller's representation that all properties underlying a

pool of transferred mortgages have undergone environmental studies and

that the studies revealed no known environmental hazards would be a

``standard representation and warranty'' (assuming that the seller

performed the requisite due diligence). This is a verifiable statement

of facts that would not be considered recourse or a direct credit

substitute.

Some commenters responding to the 1994 Notice supported this

proposed definition. Many commenters addressing the definition opposed

it. Commenters objected to the definition for the following reasons:

treating representations and warranties as recourse would place banks

at a competitive disadvantage with other institutions; representations

and warranties are not equivalent to recourse because the risk involved

may be considerably less than the risk of borrower default; and

representations and warranties that relate to operational risk should

not be recourse because recourse is supposed to address only credit

risks. Some commenters suggested the agencies replace the due diligence

requirement with a ``not known to be false'' standard.

The agencies have decided to retain the proposed definition of

standard representations and warranties for purposes of this proposal.

Where a representation or warranty functions as recourse, failure to

recognize the recourse obligation and to require appropriate capital

would create a loophole that would defeat the purposes of the proposal.

The definitions of ``recourse,'' ``direct credit substitute,'' and

``standard representations and warranties'' are intended to treat as

recourse or a direct credit substitute only those representations or

warranties that create exposure to default risk or any other form of

open-ended, credit-related risk from the assets that is not

controllable by the seller or servicer. The agencies wish to clarify

that only those representations and warranties that expose an

institution to credit risk (as opposed to interest rate risk) will be

classified as recourse or direct credit substitutes.

The proposal would treat as recourse a representation or warranty

that functions as recourse but that is guaranteed by a third party. The

agencies request comment on whether the recourse rules should place

assets subject to a representation or warranty that constitutes

recourse in the 20 percent risk weight category if a third party

guarantees the representation or warranty and has unsecured debt that

is rated in the highest rating category.

[[Page 59950]]

8. Loan Servicing Arrangements

The proposed definitions of ``recourse'' and ``direct credit

substitute'' cover loan servicing arrangements if the servicer is

responsible for credit losses associated with the loans being serviced.

However, cash advances made by residential mortgage servicers to ensure

an uninterrupted flow of payments to investors or the timely collection

of the mortgage loans are specifically excluded from the definitions of

recourse and direct credit substitute, provided that the residential

mortgage servicer is entitled to reimbursement for any significant

advances.9 Such advances are assessed risk-based capital

only against the amount of the cash advance, and are assigned to the

risk-weight category appropriate to the party obligated to reimburse

the servicer.

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

\9\ Servicer cash advances include disbursements made to cover

foreclosure costs or other expenses arising from a loan in order to

facilitate its timely collection (but not to protect investors from

incurring these expenses).

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

If the residential mortgage servicer is not entitled to full

reimbursement, then the maximum possible amount of any nonreimbursed

advances on any one loan must be contractually limited to an

insignificant amount of the outstanding principal on that loan in order

for the obligation to make cash advances to be excluded from the

definitions of recourse and direct credit substitute. This treatment

reflects the agencies' traditional view that servicer cash advances

meeting these criteria are part of the normal mortgage servicing

function and do not constitute credit enhancements.

Commenters generally supported the proposed definition of servicer

cash advances. Some commenters asked for clarification of the terms

``insignificant'' and whether ``reimbursement'' includes reimbursement

payable out of subsequent collections or reimbursement in the form of a

general claim on the party obligated to reimburse the servicer.

Nonreimbursed advances contractually limited to no more than one

percent of the amount of the outstanding principal would be considered

insignificant. Reimbursement includes reimbursement payable from

subsequent collections and reimbursement in the form of a general claim

on the party obligated to reimburse the servicer, provided that the

claim is not subordinated to other claims on the cash flows from the

underlying asset pool.

9. Spread Accounts and Overcollateralization

Several commenters requested that the agencies state in their rules

that spread accounts and overcollateralization do not impose a risk of

loss on an institution and are not recourse. By its terms, the

definition of recourse covers only the retention of risk in a sale of

assets. Neither a spread account (unless reflected on an institution's

balance sheet) nor overcollateralization ordinarily impose a risk of

loss on an institution, so neither would fall within the proposed

definition of recourse. However, a spread account reflected as an asset

on an institution's balance sheet would be a form of recourse or direct

credit substitute and would be treated accordingly for risk-based

capital purposes.

B. Treatment of Direct Credit Substitutes

The agencies are proposing to extend the current risk-based capital

treatment of asset transfers with recourse, including the low-level

recourse rule, to direct credit substitutes. As previously explained,

the current risk-based capital assessment for a direct credit

substitute such as a standby letter of credit may be dramatically lower

than the assessment for a recourse provision that creates an identical

exposure to risk. As noted previously, the OTS capital rule already

treats most direct credit substitutes (other than financial standby

letters of credit) in the same manner as recourse obligations.

Currently, an institution that sells assets with 10 percent

recourse must hold capital against the full amount of the assets

transferred. On the other hand, an institution that extends a letter of

credit covering the first 10 percent of losses on the same pool of

assets must hold capital against only the face amount of the letter of

credit. Banking organizations are taking advantage of this anomaly by

providing first loss letters of credit to asset-backed commercial paper

conduits that lend directly to corporate customers, which results in a

significantly lower capital requirement than if the loans had been on

the organizations' balance sheets and were sold with recourse.

In the 1994 Notice, the agencies proposed to change only the

treatment of direct credit substitutes that absorb the first dollars of

losses from the assets enhanced. The agencies proposed to delay

changing the treatment of other direct credit substitutes until a

multi-level approach could be implemented. Some commenters suggested

that the agencies adopt a comprehensive approach, implementing a change

in the treatment of direct credit substitutes only in the context of a

multi-level approach, and observed that a piecemeal approach would be

unduly disruptive. The agencies agree and now propose to implement the

change in the treatment of direct credit substitutes in combination

with the multi-level approach. As proposed, the multi-level approach

applies to direct credit substitutes and recourse obligations related

to asset securitizations. The agencies request comment on how the final

rule could prudently and effectively apply the multi-level approach to

direct credit substitutes and recourse obligations not related to asset

securitizations.

Several commenters objected to the proposed treatment of direct

credit substitutes as recourse. Commenters objected that the proposed

capital treatment would impair the competitive position of U.S. banks

and thrifts and that the business of providing third-party credit

enhancements has historically been safe and profitable for banks.

Notwithstanding these concerns, the agencies believe that the current

treatment of direct credit substitutes is not consistent with the

treatment of recourse obligations, and that the difference in treatment

between the two forms of credit enhancement invites institutions to

convert recourse obligations into direct credit substitutes in order to

avoid the capital requirement applicable to recourse obligations and

balance-sheet assets. The agencies request comment on the proposed

treatment of direct credit substitutes and on the effect of the

proposed treatment on the competitive position of U.S. banks.

The Banking Agencies have raised the issue of increasing the

capital requirement for direct credit substitutes and lowering the

capital requirement for highly-rated senior securities with the bank

supervisory authorities from the other countries represented on a

subgroup of the Basle Committee on Banking Supervision in an effort to

eliminate competitive inequities.

C. Multi-level Ratings-based Approach

Many asset securitizations carve up the risk of credit losses from

the underlying assets and distribute it to different parties. A credit

enhancement (that is, a recourse arrangement or direct credit

substitute) that has no prior loss protection is a ``first dollar''

loss position. There may be one or more layers of additional credit

enhancement after the first dollar loss position. Each loss position

functions as a credit enhancement for the more senior loss

[[Page 59951]]

positions in the structure. Currently, the risk-based capital standards

do not vary the rate of capital assessment with differences in credit

risk represented by different credit enhancement or loss positions.

To address this issue, the agencies are proposing a ``multi-level''

approach to assessing capital requirements on recourse obligations,

direct credit substitutes, and senior securities in asset-

securitizations based on their relative exposure to credit risk. The

agencies are proposing a ratings-based approach that would use credit

ratings from the rating agencies to measure relative exposure to credit

risk and to determine the associated risk-based capital requirement.

The use of credit ratings would provide a way for the agencies to use

market determinations of credit quality to identify different loss

positions for capital purposes in an asset securitization structure.

This may permit the agencies to give more equitable treatment to a wide

variety of transactions and structures in administering the risk-based

capital system.

Under the ratings-based approach, the capital requirement for a

recourse obligation, direct credit substitute, or senior security would

be determined as follows: 10

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

\10\ In this preamble, ``AAA'' refers to the highest investment-

grade rating, and ``AA'', ``A'', and ``BBB'' refer to other

investment-grade ratings. These rating designations are illustrative

and do not indicate any preference or endorsement of any particular

rating agency designation system.

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

A position rated in the highest investment grade rating

category would receive a 20 percent risk weight.

A position rated investment grade but not in the highest

rating category would receive one of two alternative treatments the

agencies are considering: (1) The ``face value'' option would apply a

100 percent risk weight to the book value or face amount of the

position; or (2) the ``modified gross-up'' option would apply a 50

percent risk weight to the amount of the position plus all more senior

positions. (Section II.D of this preamble discusses and provides

examples of these two alternatives.)

Recourse obligations and direct credit substitutes not

qualifying for a reduced capital charge and positions rated below

investment grade would receive ``gross-up'' treatment--the institution

holding the position would hold capital against the amount of the

position plus all more senior positions, subject to the low-level

recourse rule.11

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\11\ Under the ``gross-up'' treatment, a position is combined

with all more senior positions in the transaction. The result is

then risk-weighted based on the nature of the underlying assets. For

example, if an institution retains a first-loss position in a pool

of mortgage loans that qualify for a 50 percent risk weight, the

institution would include the full amount of the assets in the pool,

risk-weighted at 50 percent, in its risk-weighted assets for

purposes of determining its risk-based capital ratio. The ``low

level'' recourse rule limits the capital requirement for recourse

obligations to the institution's maximum contractual obligation. 12

U.S.C. 4808.

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

If a recourse obligation, direct credit substitute, or senior

security receives different ratings from the rating agencies, the

highest ratings would determine the capital treatment. For traded

positions, the single highest rating would apply. For positions that

require two ratings (see section II.C.3 of this preamble), the lower of

the two highest ratings would apply.

1. 1994 Notice

The 1994 Notice described, in an advance notice of proposed

rulemaking, a ratings-based approach under which investment grade

positions rated in the highest rating category would receive a 20

percent risk weight and other investment grade positions would receive

a 100 percent risk weight. Some commenters responding to the 1994

Notice supported the ratings-based approach described in that notice as

a flexible, efficient, market-oriented way to measure risk in

securitizations. Many commenters also noted that a ratings-based

approach was not a perfect or complete solution, especially for non-

traded positions that would otherwise not need to be rated. The

agencies recognize additional options for non-traded positions could be

useful in conjunction with or in lieu of the ratings-based approach and

are considering other approaches, which are described in section II.E

of this preamble.

In the 1994 Notice the agencies suggested that a ratings-based,

multi-level approach should be restricted to transactions involving the

securitization of large, diversified asset pools in which all forms of

first dollar loss credit enhancement are either completely free of

third-party performance risk or are provided internally as part of the

securitization structure. Additionally, the agencies had suggested that

the ratings-based approach be available only for positions other than

first-loss positions. Many commenters pointed out that credit ratings

incorporate this information and that the threshold criteria were

redundant. The agencies agree and have not included these criteria in

the proposal.

2. Effect of Ratings Downgrades

The ratings-based approach would be based on current ratings, so

that a rating downgrade or withdrawal of a rating could change the

treatment of a position under the proposal. However, a downgrade by a

single rating agency rating would not affect the capital treatment of a

position if the position still qualified for the treatment under

another rating from a different rating agency.

3. Non-traded Positions

In response to the 1994 Notice, one rating agency expressed concern

that regulatory use of ratings could undermine the integrity of the

rating process.12 Ordinarily, according to the commenter,

there is a tension between the interests of the investors who rely on

ratings and the interests of the issuers who pay rating agencies to

generate ratings. Under the ratings-based approach, the holder of a

recourse obligation or direct credit substitute that is not traded or

sold may, in some cases, ask for a rating just to qualify for a

favorable risk weight. The rating agency expressed a strong concern

that, without the counterbalancing interest of investors who will be

relying on the rating, rating agencies may have an incentive to issue

inflated ratings.

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

\12\ See T. McGuire, Moody's Investors Service, Ratings in

Regulation: A Petition to the Gorillas (1995).

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

In response to this concern, the agencies have developed proposed

criteria to reduce the possibility of inflated ratings and

inappropriate risk weights if ratings are used for a position that is

not traded. The agencies are proposing that such a position could

qualify for the ratings-based approach if: (1) It qualifies under

ratings from two different rating agencies; (2) the ratings are

publicly available; (3) the ratings are based on the same criteria used

to rate securities sold to the public; and (4) at least one position in

the securitization is traded.

For purposes of this proposal a position is considered ``traded''

if, at the time it is rated, there is a reasonable expectation that in

the near future: (1) The position may be sold to investors relying on

the rating or (2) a third party may enter into a transaction such as a

loan or repurchase agreement involving the position in which the third

party relies on the rating of the position.

In Section II.E of this preamble, the agencies describe two

alternative approaches to the ratings-based approach for non-traded

securitization positions: the ``ratings benchmark'' approach and the

``historical loss'' approach. The agencies may decide to adopt either

or both of these approaches, or portions of them, to either replace or

supplement the ratings-

[[Page 59952]]

based approach for non-traded positions.

(Question 2) How could the agencies prudently and effectively apply

the multi-level approach to direct credit substitutes and recourse

obligations not related to asset securitizations?

(Question 3) What would be the most appropriate oversight mechanism

for verifying ratings on nontraded positions? For instance, should an

institution be required to obtain a detailed explanation from the

rating agency of the basis for the rating on the non-traded position?

Should the institution be required to make this substantiating

information available to the regulatory agencies for review purposes?

(Question 4) How can the agencies determine if a rating on a non-

traded position is inappropriately high? Does any available evidence

show that regulatory rules based on ratings for traded positions have

led to inappropriately high ratings?

(Question 5). For a rated position to be considered traded, an

institution must have a reasonable expectation when the position is

rated that a sale or other transaction involving the position will take

place in the near future. The agencies request comment on this

definition and on the time period that is appropriate to use for

defining the ``near future.''

D. Face Value and Modified Gross-up Alternatives for Investment Grade

Positions Below the Highest Investment Grade Rating

1. Description of Approaches

The agencies are seeking comment on two alternative approaches for

calculating the capital requirement for investment grade positions

rated below the highest investment grade level (i.e.,

AAA).13 One alternative, the ``face value'' approach, would

apply a 100 percent risk weight to the book value or face amount of all

investment grade positions below the highest investment grade level,

regardless of their position within a securitization structure. The

other alternative, the ``modified gross-up'' approach, would gross-up

all investment grade positions below the highest investment grade level

and then apply a 50 percent risk weight to the grossed-up amount. For

senior investment grade positions below the highest investment grade

level, this approach would have the effect of applying a 50 percent

risk weight to these positions.14 The agencies seek comment

on which of these two alternative approaches should be adopted or on

possible alternatives to the two described here.

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

\13\ The option that is chosen would be applicable to the

ratings benchmark and historical loss approaches discussed later in

this preamble.

\14\ If a subordinated position receives the highest investment

grade rating, it would not be grossed up under the modified gross-up

approach. This is due to the relatively low risk implied by the

rating.

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

a. Rationale for the Modified Gross-Up Proposal.--The modified

gross-up approach is being proposed because of a concern that junior

positions that represent only a small portion of a securitization (so-

called ``thin-strip'' mezzanine positions) may qualify for an

investment grade rating despite a concentration of risk on the position

that makes them substantially more risky than investment grade whole

securities with the same underlying collateral. Some rating agencies do

not take into account the severity of loss posed by this risk

concentration when rating these mezzanine positions. Other rating

agencies do so in a way that may be insufficient for risk-based capital

purposes. (See detailed explanations in subsections b and c).

An underlying premise of the modified gross-up approach is that an

investment grade thin-strip mezzanine piece likely poses more risk of a

larger percentage loss than a similarly rated whole asset-backed

security. This additional risk is related to the variability of losses

on the mezzanine position.15

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\15\ The variability of loss can be characterized by its

variance, which measures the distribution of potential losses around

the expected loss. The larger the variance, the more likely that the

actual outcome will be further away from the expected loss. For

example, consider two securities with the same expected loss. The

first security has two possible loss scenarios, $7 and $13, that

each have a probability of 50 percent. The expected loss on this

security is $10, but its variance is 9 and its standard deviation is

3. A second security has two possible loss scenarios, $0 and $20,

that also have probabilities of 50 percent. The expected loss on

this security is also $10, but its variance is 100 and its standard

deviation is 10. The variances and standard deviations for the two

securities are very different. From a capital adequacy standpoint,

the second security poses a greater risk of loss than the first

security. Hence, the second security should have a larger capital

cushion, even though the expected loss on both positions is the

same.

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

Additionally, there is some evidence that investors account for the

additional concentration of credit risk in thin-strip mezzanine

positions by demanding higher yields for these positions. This is

especially the case for ratings that do not account for severity of

loss on the mezzanine position.

The modified gross-up capital treatment is designed to account for

the fact that a thin-strip mezzanine position and whole security with

the same credit ratings have similar credit risks and should,

therefore, have similar dollar capital requirements. Relative to the

``face value'' treatment, it would more fully account for the

concentration risk in these positions as it relates to the current

risk-based capital framework.

The modified gross-up proposal would gross-up mezzanine positions

to take into account any additional credit risk concentration that may

not be fully captured by the ratings. However, if such positions are

rated investment grade, but are below the highest investment grade

level, this proposal would place their grossed-up amounts in the 50

percent risk weight category. In addition, senior investment grade

positions below the highest investment grade level would be placed in

the 50 percent risk weight category. The 50 percent risk weight was

selected because it lies between the agencies' proposed 20 percent risk

weight for the highest investment grade level and the 100 percent risk

weight that applies to most positions below investment grade that would

be fully grossed-up in this proposed rule.

b. Concerns with Ratings Based on Probability of Default. The

agencies understand that certain rating agencies base their ratings on

the probability that the position will experience any losses,

regardless of the severity of loss on the position. These types of

ratings will be referred to as ``probability of default'' ratings.

If a rating for a security is based solely on the probability of

default (i.e., the probability of any losses), both a whole asset-

backed security and a junior security carved out of that whole security

will receive exactly the same rating. Both securities have the same

probability of default. Since the junior piece is smaller than the

whole security, any losses on the security's underlying loan pool will

create a larger loss as a percentage of the junior piece (i.e., a

higher loss severity) than the percentage loss on the larger whole

security.

Consider the following: Assume that $1,050 in commercial loans are

used to create a $1,000 whole security, Security 1, and a $50 credit

enhancement supporting Security 1. The $1,000 security receives the

lowest investment grade rating (BBB), based on the $50 credit

enhancement (the C piece). The $1,000 security is subsequently divided

into two pieces, a $900 senior piece, Security 2A (the A piece), and a

$100 junior piece, Security 2B (the B piece, which is the mezzanine

position between the A and C pieces). The senior piece receives a AAA

rating because its probability of default has decreased. The junior

piece, on its own, will still receive a BBB rating because its

[[Page 59953]]

probability of default is the same as the $1,000 whole security prior

to dividing the whole security into two pieces. The percentage impact

of any unexpected losses on the junior piece, though, can be many times

greater than that on the whole security because any losses on the

underlying pool of loans will be absorbed by the smaller principal

amount of the junior security. (See Figure 1.)

Assume that most of the risk of credit loss for the $1,050 pool of

commercial loans described previously is concentrated in the bottom

$150 portion of the loans. The credit enhancement (the C piece) would

absorb the first $50 of losses. The $100 junior piece (i.e., Security

2B, the mezzanine position) would, therefore, contain the balance of

the credit risk of the $1,000 whole security. Since most of the credit

risk of the $1,000 whole security is concentrated in this junior piece,

for capital adequacy purposes, the appropriate dollar capital charge on

the $100 junior piece and the $1,000 security should, in theory, be

approximately the same. This would produce an equal capital buffer for

positions with approximately equal credit risk. On a percentage basis,

applying the same dollar capital charge against this mezzanine position

and the whole security results in a ten-times higher percentage

requirement on the mezzanine position than the ``face value'' option

because its face value is one-tenth the size of the whole security

($100 versus $1,000).

c. Concerns with Ratings Based on Expected Losses. The agencies

understand that some ratings are provided based on expected losses

(i.e., the sum of all the possible losses weighted by the probabilities

of their occurrence) rather than just the probability of default. This

approach takes into account both the severity and likelihood of losses,

and therefore addresses some of the problems presented by the

probability of default approach. Rating agencies that use the expected

loss approach require a small increase in the credit enhancement (the C

piece) supporting the junior piece (Security 2B) in order for this

piece to obtain the same credit rating as the whole security (Security

1). While this additional credit enhancement is required to account for

the concentration of credit risk in the junior piece, for risk-based

capital purposes, the enhancement may not fully compensate for this

concentration risk. (Figure 2)

d. Concerns About Modified Gross-up Proposal. There is some concern

that the additional capital that the modified gross-up approach

requires for certain situations may be disproportionate to the extent

to which ratings, in fact, fail to capture the concentration of risk in

mezzanine positions. In particular, for multi-tier securitizations that

have several investment grade tiers below the highest investment grade

rating, the modified gross-up approach may require too much capital

when all tiers are held in the banking system because each tier would

be grossed up and placed in the 50 percent risk weight category.

Example 4 illustrates this concern.

(Question 6). The agencies request comments comparing the face

value treatment with the modified gross-up treatment, and on other

refinements the agencies could consider to address their concerns

regarding the capital charge that would apply to thin-strip mezzanine

positions under the ratings-based approach.

(Question 7). For the modified gross-up approach, the agencies have

some concern that a 50 percent risk-weighting may be inappropriate to

apply to the grossed-up positions of securitizations. If this is the

case, what should the alternative risk weight be for the grossed-up

security and what data are available to support this alternative risk

weight?

(Question 8). For a thin-strip mezzanine position, a rating agency

that uses the expected losses approach requires a higher credit

enhancement to obtain a specified rating than a rating agency that uses

the probability of loss approach because the former takes into account

the loss severity of the position. Should the agencies have different

capital standards based on which of the two approaches is used for

determining the rating for the position?

BILLING CODE 4810-33-P

[[Page 59954]]

[GRAPHIC] [TIFF OMITTED] TP05NO97.000

BILLING CODE 4810-33-C

[[Page 59955]]

2. Examples of Face Value and Modified Gross-up Approaches

The capital requirements under the modified gross-up approach would

differ substantially from a face-value treatment. The modified gross-up

approach results in a higher capital requirement for thin-strip BBB-

rated mezzanine positions than the face value approach. On the other

hand, for senior BBB-rated positions, the modified gross-up approach

results in a lower capital requirement than the face value approach.

For instance, based on the example cited previously, the modified

gross-up approach for the $100 BBB-rated mezzanine position (Security

2B) would produce a capital charge of $40 (the grossed-up amount which

is equal to Security 2A plus Security 2B, $1,000, times 50 percent

times 8 percent) while the face value approach would produce a capital

requirement of $8 (the face amount of Security 2B, $100, times 100

percent times 8 percent). For the $1,000 senior BBB-rated position

(Security 1, the whole security), the modified gross-up approach would

produce a capital requirement of $40 ($1,000 times 50 percent times 8

percent) while the face value approach would produce a capital

requirement of $80 ($1,000 times 100 percent times 8 percent).

The four following examples illustrate, for various types of

securitization structures, the capital requirements for thrifts and

banks under current rules and under the proposed face value and

modified gross-up alternatives.

Example 1

Bank A issues three classes of securities that are backed by a

$100 million pool of loans. These classes include a bottom-level

(first-loss) subordinated class of $11 million, a publicly-traded

middle-level subordinated class of $9 million, and a publicly-traded

senior class of $80 million. Bank A retains the bottom-level class

and sells the other two classes to other banks or thrifts.

Under the face value and modified gross-up approaches, Bank A,

retaining the bottom-level subordinated class, would be required to

hold risk-based capital equal to 8 percent of the $100 million pool

or $8 million (the full effective risk-based capital requirement for

the outstanding amount of the assets enhanced). Assume that because

the subordinated class provides sufficient first dollar loss

enhancement, a nationally recognized statistical rating organization

gives the $9 million publicly-traded middle class the lowest

investment grade rating. Under the face value approach, the capital

requirement for an institution holding the position would be 8

percent of $9 million or $720 thousand. Under the modified gross-up

approach the capital requirement is 4 percent (50 percent times 8

percent) of the grossed-up amount of $89 million ($9 million plus

$80 million) or $3.56 million. Finally, assume that the $80 million

senior class receives the highest credit rating, which qualifies it

for a 20 percent risk weight under both approaches. The capital

requirement for an institution holding this piece would be 1.6

percent (20 percent times 8 percent) of $80 million or $1.28

million. Table 1 summarizes this example.

Table 1.--A-B-C Structure

[Underlying Assets--$100 million of Non-Mortgage Loans]

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

Current Current

capital capital Face value Modified gross-

Position Size ($ Credit rating requirement requirement approach ($ up approach

mil) for thrifts for banks ($ mil) ($ mil)

($ mil) mil)

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

A............................................ $80 AAA.......................... $6.40 $6.40 $1.28 $1.28

B............................................ 9 BBB.......................... 7.12 0.72 0.72 3.56

C............................................ 11 Unrated...................... 8.00 8.00 8.00 8.00

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

Total Capital............................ .......... ............................. 21.52 15.12 10.00 12.84

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

Example 2

Bank A issues two classes of securities that are backed by a

$100 million pool of loans. These classes include a bottom-level

(first-loss) subordinated class of $20 million and a publicly-traded

senior class of $80 million. Bank A retains the bottom-level class

and sells the senior class to other banks or thrifts.

Under both the face value and the modified gross-up approaches,

Bank A, retaining the bottom-level subordinated class, would be

required to hold risk-based capital equal to 8 percent of the $100

million pool or $8 million (the full effective risk-based capital

requirement for the outstanding amount of the assets enhanced).

Assume that because the subordinated class provides sufficient first

dollar loss enhancement, a nationally recognized statistical rating

organization gives the $80 million publicly-traded senior class an A

rating. Under the face value approach, the capital requirement for

an institution holding position would be 8 percent of $80 million or

$6.4 million. Under the modified gross-up approach, the capital

requirement is 4 percent (50 percent times 8 percent) of the

grossed-up amount of $80 million (which, in this case, is the senior

piece) or $3.2 million. Table 2 summarizes this example.

Table 2.--A-B Structure

[Underlying Assets--$100 million of Non-Mortgage Loans]

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

Current Current

capital capital Face value Modified gross-

Position Size ($ Credit rating requirement requirement approach ($ up approach

mil) for thrifts for banks ($ mil) ($ mil)

($ mil) mil)

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

A............................................ $80 A............................ $6.40 $6.40 $6.40 $3.20

B............................................ 20 Unrated...................... 8.00 8.00 8.00 8.00

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

Total Capital............................ .......... ............................. 14.40 14.40 14.40 11.20

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

Example 3

Bank A issues four classes of securities that are backed by a

$100 million pool of mortgage loans. These classes include a bottom-

level (first-loss) subordinated class of $0.75 million (the D

position), two thin publicly-traded middle-level subordinated

classes (the B and C positions, $1.5 and $0.75 million,

respectively), and a senior class of $97 million which meets the

requirements for a SMMEA security. Bank A retains the bottom-level

class and sells the other three

[[Page 59956]]

classes to banks or thrifts. (Under current rules, the Banking

Agencies apply a 100 percent risk weight to the B and C positions,

even though the underlying assets have a 50 percent risk weight,

because the B and C positions are subordinated.)

Under both the face value and the modified gross-up approaches,

Bank A, retaining the bottom-level subordinated class, would be

required to hold risk-based capital equal to 4 percent of the $100

million pool, limited to its $0.75 million maximum exposure (low-

level recourse). Assume that because the subordinated class provides

sufficient prior credit enhancement to the classes above it, a

nationally recognized statistical rating organization gives the two

publicly-traded middle classes ratings of BBB and A and the senior

class a rating of AAA. The capital requirements for the various

tranches are as follows. The current treatment for banks holding the

$97 million AAA-rated senior mortgage position is to apply a 50

percent risk weight to the position resulting in a capital

requirement of $3.88 million ($97 million times 50 percent times 8

percent). The current treatment for thrifts holding this $97 million

position is to apply a 20 percent risk weight to the position

resulting in a capital requirement of $1.552 million ($97 million

times 20 percent times 8 percent). Under both the face value and

modified gross-up approaches, the 20 percent risk weight would apply

to the $97 million position. For the two investment grade positions

below AAA (the B and C positions), the current thrift rules require

full gross-up of the positions and the resulting capital requirement

is subject to the low-level recourse rule that limits the

requirement to the size of the position. The modified gross-up

approach results in a capital requirement exceeding the size of the

position and would also be subject to the low-level rule. The

current bank rules, which use the face value approach, would apply a

100 percent risk weight to the position. Table 3 summarizes this

example.

Table 3--Multi-Tranche Structure

[Underlying Assets--$100 million of 50 percent Risk-Weight Mortgage Loans]

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

Current Current

capital capital Face value Modified gross-

Position Size ($ Credit rating requirement requirement approach ($ up approach

mil) for thrifts for banks ($ mil) ($ mil)

($ mil) mil)

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

A............................................ $97.0 AAA.......................... $1.552 $3.880 $1.552 $1.552

B............................................ 1.5 A............................ 1.500 0.120 0.120 1.500

C............................................ 0.75 BBB.......................... 0.750 0.060 0.060 0.750

D............................................ 10.75 Unrated...................... 0.750 0.750 0.750 0.750

Total Capital............................ .......... ............................. 4.552 4.810 2.482 4.552

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

Example 4

A bank issues seven classes of securities (A through G) backed

by a $100 million pool of loans and retains a junior $6 million

subordinated interest. Additional credit enhancement available to

the class G securities enables those securities to obtain an A

rating. The other positions are rated as indicated in Table 4.

Table 4--Multi-Tranche Structure

[Underlying Assets--$100 million of Non-Mortgage Loans]

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

Current Current

capital capital Face value Modified-gross-

Position Size ($ Credit rating requirement requirement approach ($ up approach

mil) for thrifts for banks ($ mil) ($ mil)

($ mil) mil)

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

A............................................ $32 AAA.......................... $2.56 $2.56 0.51 0.51

B............................................ 21 AAA.......................... 4.24 1.68 0.34 0.34

C............................................ 17 AAA.......................... 5.60 1.36 0.27 0.27

D............................................ 6 AA........................... 6.00 0.48 0.48 3.04

E............................................ 6 A............................ 6.00 0.48 0.48 3.28

F............................................ 6 BBB.......................... 6.00 0.48 0.48 3.52

G............................................ 6 A............................ 6.00 0.48 0.48 3.76

Retained..................................... 6 Unrated...................... 6.00 6.00 6.00 6.00

Total Capital............................ .......... ............................. 42.40 13.52 9.04 20.72

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

E. Alternative Approaches

1. Ratings Benchmark Approach

a. Description of Approach. Because of some concerns with the use

of the ratings-based approach for non-traded positions, the agencies

are considering another alternative--the ratings benchmark approach.

Under this alternative, the agencies would issue benchmark guidelines

that would be used in assessing the relative credit risk of non-traded

positions in specified standardized securitization structures. The

ratings benchmarks would set credit enhancement requirements and other

pool standards for such securitizations. If a non-traded position in

such a securitization fulfills the applicable standards, and the

securitization structure includes at least one traded position, the

non-traded position will be eligible for the same capital treatment as

investment-grade positions under the ratings-based approach.

The agencies are considering this approach: (1) To recognize and

build on consensus in the market regarding the amount of prior credit

enhancement and pool standards necessary to obtain an ``A'' rating from

the rating agencies; (2) To reduce the cost and regulatory burden of

requiring institutions to obtain ratings on non-traded positions in

such securitizations; and (3) To ensure that the agencies retain

supervisory discretion to supplement the rating agencies' standards by

adding criteria that the agencies consider essential to protect the

safe operation of insured institutions.

b. Development and Application of Ratings Benchmarks. The credit

enhancement requirements and other pool standards for each type of

securitization would be based on information available from the rating

agencies regarding the relative credit risk of various types of asset

pools. The ratings benchmark for each type of pool

[[Page 59957]]

would be based on the rating agencies' requirements for credit

enhancement and other pool standards necessary for the assignment of an

``A'' rating. Relying on the ``A'' rating standard provides assurance

of a level of credit quality and permits the use of a relatively simple

benchmark, while ensuring that the noninvestment-grade positions are

not given preferential capital treatment.

The agencies would limit the application of the ratings benchmark

approach to positions in a securitization structure in which there is

at least one traded position. This limitation is intended to ensure

that the pool standards imposed on securitizations by the rating agency

selected to rate the traded position would provide an extra measure of

protection reinforcing the agencies' benchmark standards.

To be eligible for the capital treatment under the ratings

benchmark approach, the benchmarks would require a specified amount of

prior credit enhancement based on the type of asset securitization

involved. Recourse arrangements and direct credit substitutes that fail

to satisfy the applicable benchmarks would be grossed-up.16

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

\16\ If a non-traded position failed to comply with any revised

benchmark standards for the specific asset type, the position would

be subject to the gross-up approach.

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

Under the ratings benchmark approach, qualifying prior credit

enhancements include: cash collateral accounts,17

subordinated interests or classes of securities; spread

accounts,18 including those funded initially with a loan

repaid from excess cash flow; and other forms of overcollateralization

involving excess cash flows (e.g., placing excess receivables into the

pool so that total cash flows expected to be received exceed cash flows

required to pay investors). These forms of credit enhancement are

consistent with the proposal contained in the 1994 Notice which defined

prior credit enhancement for the purposes of applying the multi-level

ratings based approach.

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

\17\ A cash collateral account is a separate account funded with

a loan from the provider of the credit enhancement. Funds in the

account are available to cover potential losses.

\18\ A spread account is typically a trust or special account

that the issuer establishes to retain interest rate payments in

excess of the sum of the amounts due investors from the underlying

assets, plus a normal servicing fee rate. The excess spread serves

as a cushion to cover potential losses on the underlying loans.

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

Consistent with comments received on the 1994 Notice and the types

of credit enhancement generally relied on by the ratings agencies in

rating asset pools, the agencies would also permit forms of prior

credit enhancement involving third-party performance risk.

Specifically, the agencies would permit: pool insurance, financial

guarantees, and standby letters of credit issued or guaranteed by

companies rated or whose debt is rated, in the highest two investment

categories by two rating agencies or similar rating organizations.

Third party credit enhancements would qualify under the ratings

benchmark approach if: (1) the credit enhancement absorbs credit losses

before an institution's non-traded position absorbs losses; and (2) the

credit enhancement represents an unconditional obligation of the third

party providing the enhancement.

c. Computation of Capital Requirements under the Ratings Benchmark

Approach. Non-traded positions in asset securitizations meeting the

benchmark standards would receive the same capital treatment as

investment grade positions under the ratings-based approach (i.e.,

either the face value treatment or the modified gross-up treatment).

Eligible positions would not be subject to the full gross-up treatment.

If the agencies have not developed a ratings benchmark for a

specific type of transaction, or if a position in a securitization

structure does not qualify under an established benchmark, the non-

traded position will be subject to the full gross-up approach, unless

it otherwise qualifies for the multi-level treatment under some other

approach for non-traded positions ultimately adopted in this

rulemaking.

d. Publication of Benchmarks. Initial benchmarks are provided for

securitizations backed by residential mortgages, credit cards, auto

loans, trade receivables, and commercial real estate. The prior credit

enhancement requirements and other pool standards contained in these

initial benchmarks have been based on discussions with rating agencies

and public information submitted to the agencies in this rulemaking.

19 Public comment is solicited on all aspects of the ratings

benchmark approach, including the standards contained in the

benchmarks.

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

\19\ See Duff and Phelps Credit Rating Company Presentation to

Federal Financial Institutions Examinations Council (April 18,

1995). This document is available for public review in the FFIEC

public reference room at 2100 Pennsylvania Avenue, NW., Suite 200

Washington, DC. The benchmarks in this document, however, do not

purport to reflect the current standards of that company or any

specific rating agency.

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

If the ratings benchmark approach is adopted, the agencies would

update the benchmarks at least once every two years based on a survey

of rating agencies. The revisions to the benchmarks for each asset type

would be based on the average of the two highest enhancement

requirements of the rating agencies responding to a survey.

Additionally, if this approach is adopted, the agencies would

establish new benchmarks for additional types of securitizations based

on continuing discussions with insured institutions and rating agencies

regarding appropriate pool standards and market developments. New

benchmarks would be issued only for types of securitizations for which

the agencies believe there is a market consensus on: (1) The amount of

prior credit enhancement; and (2) the pool standards that such

securitization positions generally must satisfy to obtain the

equivalent of an ``A'' rating from rating agencies.

The biennial changes to established benchmarks and the addition of

new benchmarks would be published for notice and comment in the Federal

Register. The publication would indicate the amount of credit

enhancement required for the type of securitization, and set forth

other pool standards and restrictions. After considering any comments,

the agencies would publish the revised benchmarks in the Federal

Register.

e. Implementation. The agencies may adopt all or part of this

approach without reproposal, as modified based on comments, in the

final rule issued in this rulemaking. In addition, if the agencies

adopt this approach in the final rule, they may initially implement the

approach on a smaller scale. For example, the approach may initially be

limited to use with securitizations backed by residential mortgages,

credit card or trade receivables. Non-traded positions in other types

of securitizations would either have to qualify for some other approach

adopted in the final rule or be subject to the full gross-up approach.

f. Benchmarks. Following are draft initial ratings benchmarks for

securitizations backed by residential mortgages, credit cards,

automobile loans, trade receivables, and commercial real estate.

[[Page 59958]]

Residential Mortgage-Backed Securities

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

``Rating Benchmark'' prior credit

Pool Type 1, 2 enhancement required for ``A'' rating Pool standards

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

30-year loans........................... 1.6 percent............................... Pools include at least 400

loans for each pool type.

15-year loans 0.8 percent............................... ..........................

Adjustable Rate Mortgages (ARMs) (1,5), 2.4 percent............................... No borrower concentration

(2,6). over 3 percent for each

pool type.

Hybrid loans (fixed-to-variable)........ 2.4 percent............................... ..........................

Balloon loans........................... 2.0 percent............................... ..........................

For no documentation and reduced

documentation loans, multiply the above

enhancements by 2.

For condominiums, two-to-four family, and

cooperative apartments, multiply the

above enhancements by 2.

For B and C loans, multiply the above

enhancements by 3.

For loan-to-value (LTV) ratios equal to or

below 80 percent:

--Use above enhancements..................

--Multiply above enhancements by 2, if

there is purchase mortgage insurance

(PMI) that brings loans below 80 percent.

For LTV ratios above 80 percent, multiply

the above enhancements by 4.

For the first five years of the

securitization, the above enhancement

requirement, as a percentage of the

outstanding principal, remains fixed. For

years six through ten, the enhancement

requirement would be multiplied by 0.75.

Beyond ten years, the enhancement would

be multiplied by 0.5 3, 4 .

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

\1\ For positions that represent less than 10 percent of the size of the underlying pool of loans, add 20

percent to the enhancement level.

\2\ For closed-end second mortgage securities, determine the LTV ratio of the loans in the security and apply

the enhancement requirements for the underlying collateral. In addition, change the 15-year enhancement

requirement to 1.6 percent due to increased risk of security.

\3\ The reduction in the multiplier over time reflects the reduced risk of the mortgage portfolio due to

seasoning.

\4\ For a six-year old 15-year mortgage-backed security backed by B and C loans that have LTV ratios above 80

percent, the enhancement would be 0.8 percent x 3 x 4 x 0.75 = 7.2 percent.

Asset-Backed Securities

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

``Rating Benchmark'' prior credit

Pool Type \1\ enhancement required for ``A'' rating Pool standards

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

Credit cards \2\........................ The higher of 6 percent or 1.2 times Enhancement has access to

lagged charge-off rate \3\. excess spread.

Auto Loans:.............................

Prime (A type)...................... 7.0 percent............................... Sellers of automobile

loans must have at least

three years of historical

information.

Sub-prime (B, C, and D types)....... The higher of 15.0 percent or 3 times net Enhancement has access to

expected loss rate \4\. excess spread.

Trade Receivables....................... 12.0 percent per loan pool \5\ (if all Pools may not have seller

sellers of trade receivables are rated 1 concentrations above 5

or 2) 18.0 percent per loan pool \5\ (if percent of pool amount.

any seller of trade receivables is rated

3 or 4 and no lower than 4).

.......................................... Based on Federal Reserve

Board rating criteria for

trade receivables, each

seller must be rated

between 1 and 4.

The above enhancements will remain fixed For credit cards and auto

as a percentage of outstanding principal, loans, pool must be

with a floor of 3 percent of original randomly selected and

principal. nationally-diversified.

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

\1\ For positions that represent less than 10 percent of the size of the underlying pool of loans, add 20

percent to the credit enhancement level.

\2\ Credit cards include home equity lines of credit that are similar to credit card loans.

\3\ Lagged charge-off rate is based on the monthly average of past six month's charge-offs, multiplied by

twelve, then divided by the average outstanding balance from a year ago.

\4\ Net expected loss rate is the monthly average of last quarter's gross default amount netted against

recoveries, multiplied by twelve, then divided by the average outstanding loan balance for the last quarter.

\5\ Overcollateralization amount would count toward credit enhancement.

Commercial Mortgage-Backed Securities

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

``Rating Benchmark'' prior credit

Pool type \1\ enhancement required for ``A'' rating Pool standards

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

Office.................................. 26.0 percent.............................. Debt-service coverage at

least 1.25

[[Page 59959]]

Regional Mall........................... 10.0 percent.............................. Debt-service coverage at

least 1.35

Industrial/Anchored Retail.............. 13.0 percent.............................. Debt-service coverage at

least 1.35

Multifamily............................. 17.0 percent.............................. Debt-service coverage at

least 1.25

The above enhancements are for pools of For each type of pool

loans with loan-to-value ratios less than above:

or equal to 70 percent. For pools of --No borrower

loans with greater than 70 percent loan- concentration over 5

to-value ratio, multiply the above percent of pool amount.

enhancements by 1.5. --The amortization

schedule does not exceed

25 years.

For pools with property quality below the

B level, multiply the above enhancements

by 1.5.

The above enhancements will remain fixed

as a percentage of outstanding principal,

with a floor of 3 percent of original

principal \2\..

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

\1\ For positions that represent less than 10 percent of the underlying pool of loans, add 20 percent to the

credit enhancement level.

\2\ For example, the enhancement for a security containing regional mall loans with an 80 percent LTV ratio and

B quality property would be 10 percent x 1.5 x 1.5 = 22.5 percent.

g. Examples. To determine the dollar amount of prior credit

enhancement required for a non-traded position of a securitization, the

percentages shown in the benchmarks would be applied to the outstanding

amount of the underlying loans in the securitization and monitored

regularly by the regulatory agencies and by institutions. For example,

for residential mortgage loans, the credit enhancement for a non-traded

securitization position must be maintained at the outstanding principal

level multiplied by 100 percent of the benchmark level for years one

through five. For years six through ten, the required enhancement would

be set at 75 percent of the benchmark level. For years eleven and

beyond the enhancement requirement would be set at 50 percent of the

benchmark level.20

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

\20\ The reduction in the required credit enhancement amount

over time is due to the reduced credit risk of seasoned mortgage

loan pools.

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

Example of a Residential Mortgage Securitization. Assume an

institution has provided a 3 percent guarantee on a $6 million

mezzanine position of a $200 million residential mortgage

securitization. The junior position is a $10 million piece held by a

second institution. The underlying mortgages are 15-year fixed-rate

``B'' and ``C'' residential mortgage loans with no greater than 70

percent loan-to-value ratios (LTV), with no private mortgage insurance.

The benchmark requirement would be 0.8 percent (15-year mortgages)

times 1 (70 percent LTV ratio) times 3 (``B'' and ``C'' loans) or 2.4

percent of the securitization amount of $200 million, which equals $4.8

million. Since the $10 million junior position exceeds $4.8 million,

the guarantee would not be subject to the gross-up approach.

After one year, losses on the pool are $2 million and the size of

the pool decreases to $190 million. The benchmark requirement would be

2.4 percent of $190 million or $4.5 million. Since the junior piece of

$8 million still exceeds $4.5 million, the guarantee would still not be

subject to the gross-up approach.

Example of a Credit Card Securitization. Assume an institution has

provided a guarantee for the bottom 15 percent of a $100 million credit

card securitization. This bottom position is unrated. A third party

provides a cash collateral account of 7 percent or $7 million in front

of the unrated position. Because the pool is new, the institution must

project the annual loss experience on the pool.21 In this

case, it projects 4 percent. Based on the benchmarks, the 4 percent

should be multiplied by 1.2 and then compared with 6 percent to

determine which of the two numbers is higher. Since 6 percent is

higher, the benchmark requirement becomes 6 percent of $100 million or

$6 million. Since the cash collateral account of $7 million exceeds 6

percent of $100 million, the guarantee would receive a risk weight that

is lower than under the gross-up approach.

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

\21\ If the institution has experience with this type of pool,

then this historical experience should be used to determine the loss

rate required to determine the benchmark.

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

After one year, the pool of credit card loans decreases to $80

million. The experience on these credit card loans indicates that the

lagged loss rate of the loans is 7 percent of the pool, not 4 percent

as projected. In addition, assume the cash collateral account provided

by the third party decreases to $5 million net of excess cash flows and

pool losses. The benchmark is the higher of 6 percent or 8.4 percent

(1.2 times 7 percent). The 8.4 percent benchmark is applied to the $80

million pool resulting in a required enhancement of $6.7 million. Since

this exceeds the $5 million cash collateral account, the gross-up

approach would be applied to the guarantee. To avoid the fully-grossed-

up treatment, the third party would need to increase the cash

collateral account by $1.7 million to $6.7 million.

Example of a Trade Receivable Securitization. Assume an institution

has provided a guarantee on the bottom 12 percent portion of an asset-

backed commercial paper program. All of the seller programs within the

structure are rated 1 or 2 by the regulator. No program within the

structure represents more than 5 percent of the pool and each program

within the pool has 15 percent overcollateralization. The guarantee on

this commercial paper program would not be grossed up because it is

well-diversified, all programs are rated 1 or 2, and the over-

collateralization exceeds 12 percent.

Assume that after six months, two of the pool's

overcollateralization levels decrease to 10 percent and one of the

seller programs is rated 3. The guarantee would be subject to the

gross-up

[[Page 59960]]

approach for either of two reasons. First, none of the seller programs

have 18 percent collateral, which is the new requirement based on the

one program that is rated 3. Second, even if the one program was not

rated 3, the two programs with 10 percent collateral do not meet the 12

percent collateral requirement for 1- and 2-rated seller programs.

(Question 9) What changes, if any, should be made to the amounts of

prior credit enhancement and the pool standards required by the

agencies' benchmarks? Please provide supporting information, if

available.

(Question 10) Can the benchmark standards be simplified without

unduly relaxing the protection afforded to institutions by these

standards?

(Question 11) What additional types of pools and securitization

transactions are sufficiently standardized and homogenous to permit the

agencies to develop reliable benchmarks? Would it be reasonable to

handle these securitizations on a case-by-case basis using the best

available data from the rating agencies at the time of the

securitization?

(Question 12) Is the biennial review and update of the benchmarks

appropriate?

(Question 13) Please comment on ways the agencies could most

effectively evaluate and monitor institutions' use of ratings

benchmarks in the examination process with the least possible burden on

institutions and examiners.

(Question 14) Should the agencies adopt both the ratings-based

approach and ratings benchmark approach for non-traded positions?

Alternatively, should the agencies adopt only one of these approaches

for non-traded positions in rated securitizations?

(Question 15) If the agencies decide to adopt both approaches,

should institutions be given the discretion to elect which of these

approaches to use for their non-traded positions? On the other hand, if

the agencies adopt the ratings benchmark approach, should the ratings-

based approach be used for non-traded positions in securitizations for

which a benchmark has not been developed?

(Question 16) Please compare the relative financial and operational

burdens that would be imposed on institutions by the ratings-based

approach and ratings benchmark approach for non-traded positions.

2. Internal Information Approaches

In response to the 1994 Notice, the agencies also received several

comments proposing approaches under which an institution would use

credit information it has about the underlying assets to set the

capital requirement for a position. These commenters observed that

evaluating credit risks is a traditional area of bank expertise and

that an institution knows its own assets better than anyone else.

The agencies agree that using the information that institutions

have about the credit quality of assets underlying a position could, if

feasible, be more efficient than any of the ratings-based approaches

for assessing capital requirements on non-traded positions. Therefore,

the agencies are considering two approaches based on this type of

information: the ``historical loss'' approach and the ``bank model''

approach. The agencies may adopt all or part of this historical loss

approach in the final rule adopted in this rulemaking without

reproposal. Accordingly, the agencies solicit comments and supporting

information to aid in their development of the historical loss and bank

model approaches.

a. Historical Loss Approach. A principal purpose of regulatory

capital is to provide a cushion against unexpected losses. The

historical loss approach being considered by the agencies would take

unexpected losses over the life of the asset pool into account. These

losses may not be taken into account fully in the ratings-based

approaches. The historical loss approach, however, bases the risk-based

capital treatment for a position in a securitization on the

characteristics of the underlying pool of assets, including the

variance of losses. This variance is the source of unexpected losses.

While the historical loss approach could, in theory, be used for all

recourse obligations and direct credit substitutes, the agencies are

proposing that the approach initially be applied only to non-traded

positions in securitizations with at least one traded position.

To measure the variance of losses on a pool of assets, an

institution would have to project the probability distribution of the

cumulative losses on the underlying assets over the life of the pool

based on historical loss information for assets comparable to those in

the pool. Comparability would encompass such factors as credit quality,

collateral, and repayment terms. The cumulative losses would be the

portion of the assets in the pool that would not be recovered over the

life of the pool.

Under this approach, the risk-based capital treatment for a non-

traded position would depend on the expected value of losses on the

underlying pool, plus a specified number of standard deviations. As a

general rule, at the inception of a securitization, the holder or

issuer of a non-traded position would determine whether the holder

would incur a loss if the cumulative losses on the underlying assets in

the pool reached the expected value of losses plus the designated

number of standard deviations (e.g., expected loss plus five standard

deviations for normal distributions). This determination would consider

any available qualifying credit enhancements providing support to the

position and the existence of any more junior positions in the

securitization.

Thus, the expected value of losses plus the designated number of

standard deviations would serve as a boundary. If the holder of a non-

traded position would suffer a loss when the level of cumulative losses

on the underlying assets in the pool reached this boundary, then the

position would receive the gross-up treatment. The institution's

capital requirement, however, would be subject to the low-level rule.

Otherwise, the position would qualify to be treated in the same manner

as traded positions with ratings below ``AAA'' under the multi-level,

ratings-based approach. In short, the non-traded position would qualify

to use either the face value treatment or the ``modified gross-up''

approach, depending upon which of these proposed alternatives the

agencies adopt in their final rules (see sections II.C and II.D of this

preamble). An institution's estimate of the probability distribution,

measurement of the variance, assessment of the support provided by

credit enhancements, and determination of the loss exposure on a non-

traded position, as well as the resulting risk-based capital treatment

of the position, would be subject to review by examiners.

In projecting the probability distribution of the losses on a

pool's underlying assets, an institution would need to compile and

analyze historical loss information for individual assets that are

comparable to those in the pool. This would include considering the

size of the losses on individual assets and, depending on the type of

credit enhancement supporting the securitization, the amount of time

after the origination of the type of assets being securitized when

losses generally occur on that asset type. This information may be

available from the information the issuer supplies to the rating

agencies for their use in rating the securitization's traded positions.

The agencies are proposing that the types of credit enhancement

that would qualify to be considered when determining whether the holder

of a

[[Page 59961]]

non-traded position would incur any losses be the same as those

proposed under the ratings benchmark approach. The size or availability

of one or more of the credit enhancements in a securitization (e.g., a

spread account), however, may vary over time based on the performance

of the pool's underlying assets. If such a credit enhancement supports

one or more of the positions in a securitization, the institution also

would need to consider the shape of the loss curve over the life of the

pool that produces cumulative losses over that period equal to the

expected value of losses, plus the designated number of standard

deviations. In this situation, as a supplement to the general rule

cited previously, the size of the credit enhancement that would be

available at any point over the life of the pool given the loss curve's

indicated level of losses would need to be sufficient to prevent the

holder of a non-traded position from suffering a loss in order for the

non-traded position to avoid application of the gross-up approach.

As an example of the application of this historical loss approach,

assume an institution owns a non-traded $100 subordinated piece of a

$1,000 securitized asset pool. A qualifying standby letter of credit

issued by a bank will absorb the first $20 of losses for the pool,

thereby providing partial protection to the institution's subordinated

position. For asset pools of this type, the institution determines that

the expected value of losses plus the designated number of standard

deviations over the life of the pool is $80. Given the size of the

credit enhancement, the institution will sustain a loss of $60 on its

subordinated interest if pool losses reach the expected value of

losses, plus the designated number of standard deviations. Therefore,

the institution's position would be subject to the gross-up approach.

Capital would be held for the institution's position plus all more

senior positions. After considering the $20 qualifying standby letter

of credit (which would be treated as a bank guarantee on part of the

pool) and assuming the assets in the pool are risk-weighted at 100

percent, the risk-based capital charge for the subordinated piece would

be $78.72 [($20 x 20 percent x 8 percent) + ($980 x 100 percent x 8

percent)].

In contrast, if the expected value of losses plus the designated

number of standard deviations over the life of the pool in the

preceding example were only $19, the $20 credit enhancement would fully

absorb those losses and the institution would not expect to incur any

losses on its subordinated position. The institution's position would

qualify for the capital treatment applicable to traded investment-grade

positions rated below ``AAA.''

Based on discussions with market participants, the agencies believe

that those institutions that are active in the securitization business

will normally possess historical loss data for assets comparable to

those they are securitizing. In this regard, these institutions must be

capable of measuring and monitoring the credit risk they have retained

or assumed in securitizations to conduct their securitization

activities in a safe and sound manner. If an institution were unable to

do the statistical analysis necessary to implement this proposed

historical loss approach, however, its non-traded positions would be

subject to the gross-up approach.

(Question 17) Given the varying number of years in the life of a

pool for different types of assets, what is the minimum number of years

of historical loss data that should be used to project the probability

distribution of the cumulative losses on each type of underlying asset

pool over the pool's life? If information for the minimum number of

years is not available, is it reasonable for institutions to be

required to apply the gross-up approach to non-traded positions?

(Question 18) How should institutions determine whether the capital

requirement for a non-traded position should be changed over time?

Should institutions periodically adjust the loss distribution that they

used to set their initial capital requirement to reflect actual losses

on pool assets over the life of the pool?

(Question 19) Is it reasonable for the agencies to use a log normal

curve to describe the distribution of losses on a pool of assets? Would

another approach be preferable and, if so, why would it be preferable?

(Question 20) Would this approach be applicable to all asset types

or are there some asset types with unusual characteristics for which

this approach would be inappropriate?

(Question 21) How burdensome would this historical loss approach be

for institutions? To what extent is the necessary loss data available?

What modifications should the agencies consider making as they develop

this approach?

b. Bank Model Approach. Commenters on the 1994 Notice suggested

that the capital requirements for recourse obligations and direct

credit substitutes also could be based on internal risk assessments

made by banks holding those positions. Over the past decade, some

banking organizations have developed, for their own internal risk

management purposes, statistical techniques for quantifying the credit

risk in sub-portfolios of credit instruments such as direct credit

substitutes. In principle, these ``internal models'' for measuring

credit risk could be used in setting capital requirements for direct

credit substitutes and possibly other credit positions. Such a system

would be broadly consistent with both the internal models approach to

capital now being implemented for market risks associated with bank

trading activities, as well as with current supervisory policies for

evaluating the adequacy of the allowance for loan and lease losses.

Currently, the agencies are uncertain whether an internal model

approach is feasible. However, the agencies recognize that the

development of an internal model approach to capital for direct credit

substitutes, and perhaps for other credit instruments, could have

significant benefits. For example, under the ratings approach, a bank's

internal risk assessment--if acceptable to supervisors--might

substitute for a credit rating, thus reducing costs and delays

associated with obtaining credit ratings. Alternatively, an acceptable

internal model for measuring credit risk might form the basis for

assessing capital requirements on a portfolio basis rather than on an

asset-by-asset basis, thus better reflecting a bank's diversification

and hedging activities.

The agencies note that securitization activities can create

positions that add significantly to the volatility, appropriately

measured, of an institution's credit losses. Banks for which such

activities are significant should have in place appropriate policies

and practices to quantify and manage the credit risk associated with

securitization. The agencies, as always, will review the quality of

such policies and practices within the context of evaluating the

overall quality of a bank's risk management processes.

(Question 22) Is an internal model approach to setting capital

requirements for recourse, direct credit substitutes, and other credit

instruments currently feasible and, if so, how might it be structured?

(Question 23) Which types of credit activities would be amenable to

such an approach?

(Question 24) How could the agencies validate such internal models

and their credit risk assessments?

III. Regulatory Flexibility Act

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

the OCC

[[Page 59962]]

certifies that this proposal will not have a significant impact on a

substantial number of small entities. 5 U.S.C. 601 et seq. The

provisions of this proposal that increase capital requirements are

likely to affect large banks almost exclusively. (Small banks are

unlikely to be in a position to provide direct credit substitutes in

asset securitizations.) Accordingly, a regulatory flexibility analysis

is not required.

Board: Pursuant to section 605(b) of the Regulatory Flexibility

Act, the Board does not believe this proposal will have a significant

impact on a substantial number of small business entities in accord

with the spirit and purposes of the Regulatory Flexibility Act (5

U.S.C. 601 et seq.). The Board's comparison of the applicability

section of this proposal with Call Report Data on all existing banks

shows that application of the rule to small entities will be the rare

exception. Accordingly, a regulatory flexibility analysis is not

required. In addition, because the risk-based capital standards

generally do not apply to bank holding companies with consolidated

assets of less than $150 million, this rule will not affect such

companies.

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

(Pub. L. 96-354, 5 U.S.C. 601 et seq.), the FDIC certifies that the

proposed rule will not have a significant impact on a substantial

number of small entities. Comparison of Call Report data on FDIC-

supervised banks to the items covered by the proposal that result in

increased capital requirements shows that application of the rule to

small entities will be the infrequent exception.

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

the OTS certifies that this proposal will not have a significant impact

on a substantial number of small entities. The proposal is likely to

reduce slightly the risk-based capital requirements for recourse

obligations and direct credit substitutes, except for some standby

letters of credit. Thrifts currently issue few, if any, standby letters

of credit. Accordingly, a regulatory flexibility analysis is not

required.

IV. Paperwork Reduction Act

Board: In accordance with the Paperwork Reduction Act of 1995 (44

U.S.C. Ch. 3506; 5 CFR 1320 Appendix A.1), the Board reviewed the

proposed rule under the authority delegated to the Board by the Office

of Management and Budget. No collections of information pursuant to the

Paperwork Reduction Act are contained in the proposed rule.

V. Executive Order 12866

OCC: On the basis of the best information available, the OCC has

determined that this proposal is not a significant regulatory action

for purposes of Executive Order 12866. However, the impact of any final

rule resulting from this proposal will depend on factors for which the

agencies do not currently collect industry-wide information, such as

the proportion of bank-provided direct credit substitutes that would be

rated below investment grade. The OCC therefore welcomes any

quantitative information national banks wish to provide about the

impact they expect the various portions of this proposal to have if

issued in final form.

OTS: The Director of the OTS has determined that this proposal does

not constitute a ``significant regulatory action'' under Executive

Order 12866. The proposal is likely to reduce slightly the risk-based

capital requirements for recourse obligations and direct credit

substitutes, except for some standby letters of credit. Thrifts

currently issue few, if any, standby letters of credit. As a result,

the OTS has concluded that the proposal will have only minor effects on

the thrift industry.

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

Section 202 of the Unfunded Mandates Reform Act of 1995 (Unfunded

Mandates Act), requires that an agency prepare a budgetary impact

statement before promulgating a rule that includes a Federal mandate

that may result in the expenditure by state, local, and tribal

governments, in the aggregate, or by the private sector, of $100

million or more in any one year. If a budgetary impact statement is

required, section 205 of the Unfunded Mandates Act also requires an

agency to identify and consider a reasonable number of regulatory

alternatives before promulgating a rule. The OCC and OTS have

determined that this proposal will not result in expenditures by state,

local, and tribal governments, or by the private sector, of more than

$100 million or more in any one year. Therefore, the OCC and OTS have

not prepared a budgetary impact statement or specifically addressed the

regulatory alternatives considered. As discussed in the preamble, this

proposal rule will correct certain inconsistencies in the agencies'

risk-based capital standards and will allow banking organizations to

maintain lower amounts of capital against certain rated recourse

obligations and direct credit substitutes.

List of Subjects

12 CFR Part 3

Administrative practice and procedure, Capital, National banks,

Reporting and recordkeeping requirements, Risk.

12 CFR Part 208

Accounting, Agriculture, Banks, banking, Confidential business

information, Crime, Currency, Federal Reserve System, Mortgages,

Reporting and recordkeeping requirements, Securities.

12 CFR Part 225

Administrative practice and procedure, Banks, banking, Federal

Reserve System, Holding companies, Reporting and recordkeeping

requirements, Securities.

12 CFR Part 325

Administrative practice and procedure, Banks, banking, Capital

adequacy, Reporting and recordkeeping requirements, Savings

associations, State non-member banks.

12 CFR Part 567

Capital, Reporting and recordkeeping requirements, Savings

associations.

Office of the Comptroller of the Currency

12 CFR Chapter I

Authority and Issuance

For the reasons set out in the preamble, appendix A of part 3 of

chapter I of title 12 of the Code of Federal Regulations is proposed to

be amended as follows:

PART 3--MINIMUM CAPITAL RATIOS; ISSUANCE OF DIRECTIVES

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

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

note, 1835, 3907 and 3909.

2. In part 3, appendix A, section 3, paragraph (b) is amended by

adding a new sentence at the end of the introductory text; paragraph

(b)(1)(i) and footnote 13 are removed and reserved; paragraph

(b)(1)(ii) is revised; paragraph (b)(1)(iii) and footnote 14 are

removed and reserved; footnote 16 in paragraph (b)(2)(i) and footnote

17 in paragraph (b)(2)(ii) are revised; and paragraph (d) is revised to

read as follows:

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

* * * * *

[[Page 59963]]

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

Off-Balance Sheet Items

* * * * *

(b) * * * However, direct credit substitutes, recourse

obligations, and securities issued in connection with asset

securitizations are treated as described in section 3(d) of this

appendix A.

(1) * * *

(ii) Risk participations purchased in bankers' acceptances.

* * * * *

(2) * * *

(i) * * * 16* * *

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

\16\ Participations in performance-based standby letters of

credit are treated in accordance with section 3(d) of this appendix

A.

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

(ii) * * * 17* * *

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

\17\ Participations in commitments are treated in accordance

with section 3(d) of this appendix A.

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

* * * * *

(d) Recourse obligations, direct credit substitutes, and asset-

and mortgage-backed securities. (1) Definitions. For purposes of

this section 3 of this appendix A:

(i) Direct credit substitute means an arrangement in which a

national bank assumes, in form or in substance, any risk of credit

loss directly or indirectly associated with a third-party asset or

other financial claim, that exceeds the national bank's pro rata

share of the asset or claim. If a national bank has no claim on the

asset, then the assumption of any risk of credit loss is a direct

credit substitute. Direct credit substitutes include, but are not

limited to:

(A) Financial guarantee-type standby letters of credit that

support financial claims on the account party;

(B) Guarantees, surety arrangements, and irrevocable guarantee-

type instruments backing financial claims;

(C) Purchased subordinated interests or securities that absorb

more than their pro rata share of losses from the underlying assets;

(D) Loans or lines of credit that provide credit enhancement for

the financial obligations of an account party; and

(E) Purchased loan servicing assets if the servicer is

responsible for credit losses associated with the loans being

serviced (other than servicer cash advances as defined in section

3(d)(1)(v) of this appendix A), or if the servicer makes or assumes

representations and warranties on the loans (other than standard

representations and warranties as defined in section 3(d)(1)(vi) of

this appendix A).

(ii) Financial guarantee-type standby letter of credit means any

letter of credit or similar arrangement, however named or described,

which represents an irrevocable obligation to the beneficiary on the

part of the issuer:

(A) To repay money borrowed by, or advanced to, or for the

account of, an account party; or

(B) To make payment on account of any indebtedness undertaken by

an account party, in the event that the account party fails to

fulfill its obligation to the beneficiary.

(iii) Rated means, with respect to an instrument or obligation,

that the instrument or obligation has received a credit rating from

a nationally-recognized statistical rating organization. An

instrument or obligation is rated investment grade if it has

received a credit rating that falls within one of the four highest

rating categories used by the nationally-recognized statistical

rating organization. An instrument or obligation is rated in the

highest investment grade category if it has received a credit rating

that falls within the highest investment grade category used by the

nationally-recognized statistical rating organization.

(iv) Recourse means the retention in form or substance of any

risk of credit loss directly or indirectly associated with a

transferred asset that exceeds a pro rata share of a national bank's

claim on the asset. If a national bank has no claim on a transferred

asset, then the retention of any risk of credit loss is recourse. A

recourse obligation typically arises when an institution transfers

assets and retains an obligation to repurchase the assets or to

absorb losses due to a default of principal or interest or any other

deficiency in the performance of the underlying obligor or some

other party. Recourse may exist implicitly where a bank provides

credit enhancement beyond any contractual obligation to support

assets it has sold. Recourse obligations include, but are not

limited to:

(A) Representations and warranties on the transferred assets

(other than standard representations and warranties as defined in

section 3(d)(1)(vi) of this appendix A);

(B) Retained loan servicing assets if the servicer is

responsible for losses associated with the loans serviced (other

than a servicer cash advance as defined in section 3(d)(1)(v) of

this appendix A);

(C) Retained subordinated interests or securities that absorb

more than their pro rata share of losses from the underlying assets;

(D) Assets sold under an agreement to repurchase; and

(E) Loan strips sold without direct recourse where the maturity

of the transferred loan is shorter than the maturity of the

commitment.

(v) Servicer cash advance means funds that a residential

mortgage loan servicer advances to ensure an uninterrupted flow of

payments or the timely collection of residential mortgage loans,

including disbursements made to cover foreclosure costs or other

expenses arising from a mortgage loan to facilitate its timely

collection. A servicer cash advance is not a recourse obligation or

a direct credit substitute if:

(A) The mortgage servicer is entitled to full reimbursement; or

(B) For any one mortgage loan, nonreimbursable advances are

contractually limited to an insignificant amount of the outstanding

principal on that loan.

(vi) Standard representations and warranties means contractual

provisions that a national bank extends when it transfers assets

(including loan servicing assets), or assumes when it purchases loan

servicing assets. To qualify as a standard representation or

warranty, a contractual provision must:

(A) Refer to facts that the seller or servicer can verify, and

has verified with reasonable due diligence, prior to the time that

assets are transferred (or servicing assets are acquired);

(B) Refer to a condition that is within the control of the

seller or servicer; or

(C) Provide for the return of assets in the event of fraud or

documentation deficiencies.

(vii) Traded position means a recourse obligation, direct credit

substitute, or asset- or mortgage-backed security that is retained,

assumed, or issued in connection with an asset securitization and

that was rated with a reasonable expectation that, in the near

future:

(A) The position would be sold to investors relying on the

rating; or

(B) A third party would, in reliance on the rating, enter into a

transaction such as a purchase, loan or repurchase agreement

involving the position.

(2) Risk-weighted asset amount. Except as otherwise provided in

sections 3(d)(3) and (4) of this appendix A, to calculate the risk-

weighted asset amount for a recourse obligation or direct credit

substitute, multiply the amount of assets from which risk of credit

loss is directly or indirectly retained or assumed, by the

appropriate risk weight using the criteria regarding obligors,

guarantors, and collateral listed in section 3(a) of this appendix

A. For purposes of this section 3(d) of this appendix A, the amount

of assets from which risk of credit loss is directly or indirectly

retained or assumed means:

(i) For a financial guarantee-type standby letter of credit,

surety arrangement, guarantee, or irrevocable guarantee-type

instrument, the amount of the assets that the direct credit

substitute fully or partially supports;

(ii) For a subordinated interest or security, the amount of the

subordinated interest or security plus all more senior interests or

securities;

(iii) For mortgage servicing rights that are recourse

obligations or direct credit substitutes, the outstanding amount of

the loans serviced;

(iv) For representations and warranties (other than standard

representations and warranties), the amount of the assets subject to

the representations or warranties;

(v) For loans on lines of credit that provide credit enhancement

for the financial obligations of an account party, the amount of the

enhanced financial obligations;

(vi) For loans strips, the amount of the loans; and

(vii) For assets sold with recourse, the amount of assets from

which risk of credit loss is directly or indirectly retained or

assumed, less any applicable recourse liability account established

in accordance with generally accepted accounting principles.

(3) Investment grade recourse obligations, direct credit

substitutes, and asset-and mortgage-backed securities. (i)

Eligibility. A traded position is eligible for the treatment

described in this section 3(d)(3) of this appendix A if it has been

rated investment grade by a nationally-recognized statistical rating

organization. A recourse obligation or direct credit substitute that

is not a traded position is eligible for the treatment described in

this section 3(d)(3) of this

[[Page 59964]]

appendix A if it has been rated investment grade by two nationally-

recognized statistical rating organizations, the ratings are

publicly available, the ratings are based on the same criteria used

to rate securities sold to the public, and the recourse obligation

or direct credit substitute provide credit enhancement to a

securitization in which at least one position is traded.

(ii) Highest investment grade. To calculate the risk-weighted

asset amount for a recourse obligation, direct credit substitute, or

asset-or mortgage-backed security that is rated in the highest

investment grade category, multiply the face amount of the position

by a risk weight of 20 percent.

(iii) Other investment grade.

[Option 1--Face Value Treatment] To calculate the risk-weighted

asset amount for a recourse obligation, direct credit substitute, or

asset- or mortgage-backed security that is rated investment grade,

multiply the face amount of the position by a risk weight of 100

percent.

[Option 2--Modified Gross-Up] To calculate the risk-weighted

asset amount for a recourse obligation, direct credit substitute, or

asset- or mortgage-backed security that is rated investment grade,

multiply the amount of assets from which risk of credit loss is

directly or indirectly retained or assumed by a risk weight of 50

percent.

(4) Participations. The risk-weighted asset amount for a

participation interest in a direct credit substitute is calculated

as follows:

(i) Determine the risk-weighted asset amount for the direct

credit substitute as if the bank held all of the interests in the

participation.

(ii) Multiply the risk-weighted asset amount determined under

section 3(d)(4)(i) of this appendix A by the percentage of the

bank's participation interest.

(iii) If the bank is exposed to more than its pro rata share of

the risk of credit loss on the direct credit substitute (e.g., the

bank remains secondarily liable on participations held by others),

add to the amount computed under section 3(d)(4)(ii) of this

appendix A an amount computed as follows: multiply the amount of the

direct credit substitute by the percentage of the direct credit

substitute held by others and then multiply the result by the lesser

of the risk-weight appropriate for the holders of those interests or

the risk weight appropriate for the direct credit substitute.

(5) Limitations on risk-based capital requirements. (i) Low-

level recourse. If the maximum contractual liability or exposure to

credit loss retained or assumed by a bank in connection with a

recourse obligation or a direct credit substitute is less than the

effective risk-based capital requirement for the enhanced assets,

the risk-based capital requirement is limited to the maximum

contractual liability or exposure to loss, less any recourse

liability account established in accordance with generally accepted

accounting principles. This limitation does not apply to assets sold

with implicit recourse.

(ii) Mortgage-related securities or participation certificates

retained in a mortgage loan swap. If a bank holds a mortgage-related

security or a participation certificate as a result of a mortgage

loan swap with recourse, capital is required to support the recourse

obligation plus the percentage of the mortgage-related security or

participation certificate that is not protected against risk of loss

by the recourse obligation. The total amount of capital required for

the on-balance sheet asset and the recourse obligation, however, is

limited to the capital requirement for the underlying loans,

calculated as if the bank continued to hold these loans as an on-

balance sheet asset.

(iii) Related on-balance sheet assets. To the extent that an

asset is included in the calculation of the risk-based capital

requirement under this section 3(d) of this appendix A and may also

be included as an on-balance sheet asset, the asset is risk-weighted

only under this section 3(d) of this appendix A except that mortgage

servicing assets and similar arrangements with embedded recourse

obligations or direct credit substitutes are risk-weighted as on-

balance sheet assets and related recourse obligations and direct

credit substitutes are risk-weighted under this section 3(d) of this

appendix A.

* * * * *

3. In appendix A, Table 2, item 1 under ``100 Percent Conversion

Factor'' is revised to read as follows:

* * * * *

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

100 Percent Conversion Factor

1. [Reserved]

* * * * *

Dated: October 22, 1997.

Eugene A. Ludwig,

Comptroller of the Currency.

Federal Reserve System

12 CFR Chapter II

For the reasons set forth in the joint preamble, parts 208 and 225

of chapter II of title 12 of the Code of Federal Regulations are

proposed to be amended as follows:

PART 208--MEMBERSHIP OF STATE BANKING INSTITUTIONS IN THE FEDERAL

RESERVE SYSTEM (REGULATION H)

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

follows:

Authority: 12 U.S.C. 24, 36, 92a, 93a, 248(a), 248(c), 321-338a,

371d, 461, 481-486, 601, 611, 1814, 1816, 1818, 1820(d)(9), 1823(j),

1828(o), 1831o, 1831p-1,1831 r-1, 1835a, 1882, 2901-2907, 3105,

3310, 3331-3351, and 3906-3909; 15 U.S.C. 78b, 78l(b), 78l(g),

78l(i), 78o-4(c)(5), 78q, 78q-1, and 78w; 31 U.S.C. 5318; 42 U.S.C.

4012a, 4104a, 4104b, 4106, and 4128.

2. In appendix A to part 208, section III.B. is amended by revising

paragraph 3. and in paragraph 4., footnote 24 is redesignated as

footnote 28. The revision reads as follows:

Appendix A to Part 208--Capital Adequacy Guidelines for State Member

Banks: Risk-Based Measure

* * * * *

III. * * *

B. * * *

3. Recourse obligations, direct credit substitutes, and asset -

and mortgage-backed securities. Direct credit substitutes, assets

transferred with recourse, and securities issued in connection with

asset securitizations are treated as described below.

(a) Definitions-- (1) Direct credit substitute means an

arrangement in which a bank assumes, in form or in substance, any

risk of credit loss directly or indirectly associated with a third-

party asset or other financial claim, that exceeds the bank's pro

rata share of the asset or claim. If the bank has no claim on the

asset, then the assumption of any risk of loss is a direct credit

substitute. Direct credit substitutes include, but are not limited

to:

(i) Financial guarantee-type standby letters of credit that

support financial claims on the account party;

(ii) Guarantees, surety arrangements, and irrevocable guarantee-

type instruments backing financial claims such as outstanding

securities, loans, or other financial liabilities, or that back off-

balance-sheet items against which risk-based capital must be

maintained;

(iii) Purchased subordinated interests or securities that absorb

more than their pro rata share of losses from the underlying assets;

(iv) Loans or lines of credit that provide credit enhancement

for the financial obligations of an account party; and

(v) Purchased loan servicing assets if the servicer is

responsible for credit losses associated with the loans being

serviced (other than mortgage servicer cash advances as defined in

paragraph III.B.3.(a)(3) of this appendix A), or if the servicer

makes or assumes representations and warranties on the loans other

than standard representations and warranties as defined in paragraph

III.B.3.(a)(6) of this appendix A.

(2) Financial guarantee-type standby letter of credit means any

letter of credit or similar arrangement, however named or described,

that represents an irrevocable obligation to the beneficiary on the

part of the issuer:

(i) To repay money borrowed by, advanced to, or for the account

of, the account party; or

(ii) To make payment on account of any indebtedness undertaken

by the account party in the event that the account party fails to

fulfill its obligation to the beneficiary.

(3) Mortgage servicer cash advance means funds that a

residential mortgage loan servicer advances to ensure an

uninterrupted flow of payments or the timely collection of

residential mortgage loans, including disbursements made to cover

foreclosure costs or other expenses arising from a mortgage loan to

facilitate its timely collection. A servicer cash advance is not a

recourse obligation or a direct credit substitute if the mortgage

servicer is entitled to full reimbursement or, for any one

residential mortgage loan, nonreimbursable

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advances are contractually limited to an insignificant amount of the

outstanding principal on that loan.

(4) Rated means, with respect to an instrument or obligation,

that the instrument or obligation has received a credit rating from

a nationally-recognized statistical rating organization. An

instrument or obligation is rated investment grade if it has

received a credit rating that falls within one of the four highest

rating categories used by the organization, e.g., at least BBB or

its equivalent. An instrument or obligation is rated in the highest

investment grade if it has received a credit rating that falls

within the highest rating category used by the organization.

(5) Recourse means an arrangement in which a bank retains, in

form or in substance, any risk of credit loss directly or indirectly

associated with a transferred asset that exceeds a pro rata share of

the bank's claim on the asset. If a bank has no claim on a

transferred asset, then the retention of any risk of loss is

recourse. A recourse obligation typically arises when an institution

transfers assets and retains an obligation to repurchase the assets

or absorb losses due to a default of principal or interest or any

other deficiency in the performance of the underlying obligor or

some other party. Recourse may exist implicitly where a bank

provides credit enhancement beyond any contractual obligation to

support assets it has sold. Recourse obligations include, but are

not limited to:

(i) Representations and warranties on the transferred assets

other than standard representations and warranties as defined in

paragraph III.B.3.(a)(6) of this appendix A;

(ii) Retained loan servicing assets if the servicer is

responsible for losses associated with the loans being serviced

other than mortgage servicer cash advances as defined in paragraph

III.B.3.(a)(3) of this appendix A;

(iii) Retained subordinated interests or securities that absorb

more than their pro rata share of losses from the underlying assets;

(iv) Assets sold under an agreement to repurchase; and

(v) Loan strips sold without direct recourse where the maturity

of the transferred loan that is drawn is shorter than the maturity

of the commitment.

(6) Standard representations and warranties means contractual

provisions that a bank extends when it transfers assets (including

loan servicing assets) or assumes when it purchases loan servicing

assets. To qualify as a standard representation or warranty, a

contractual provision must:

(i) Refer to facts that the seller or servicer can verify, and

has verified with reasonable due diligence, prior to the time that

assets are transferred (or servicing assets are acquired);

(ii) Refer to a condition that is within the control of the

seller or servicer; or

(iii) Provide for the return of assets in the event of fraud or

documentation deficiencies.

(7) Traded position means a recourse obligation, direct credit

substitute, or asset- or mortgage-backed security that is retained,

assumed, or issued in connection with an asset securitization and

that is rated with a reasonable expectation that, in the near

future:

(i) The position would be sold to investors relying on the

rating; or

(ii) A third party would, in reliance on the rating, enter into

a transaction such as a purchase, loan, or repurchase agreement

involving the position.

(b) Amount of position to be included in risk-weighted assets--

(1) Determining the credit equivalent amount of recourse obligations

and direct credit substitutes. The credit equivalent amount for a

recourse obligation or direct credit substitute (except as otherwise

provided in paragraph III.B.3.(b)(2) of this appendix A) is the full

amount of the credit enhanced assets from which risk of credit loss

is directly or indirectly retained or assumed. This credit

equivalent amount is assigned to the risk weight appropriate to the

obligor, or if relevant, the guarantor or nature of any collateral.

Thus, a bank that extends a partial direct credit substitute, e.g.,

a standby letter of credit that absorbs the first 10 percent of loss

on a transaction, must maintain capital against the full amount of

the assets being supported. Furthermore, for direct credit

substitutes that are on-balance sheet, e.g., purchased subordinated

securities, banks must maintain capital against the amount of the

direct credit substitutes and the full amounts of the assets being

supported, i.e., all more senior positions. This treatment is

subject to the low-level recourse rule discussed in section

III.B.3.(c)(1) of this appendix A. For purposes of this appendix A,

the full amount of the credit

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