Board: Thomas R. Boemio, SeniorSupervisory Financial Analyst, (202)452–2982, or Norah Barger, AssistantDirector (202) 452–2402, Division ofBanking Supervision and Regulation.For the hearing impaired only,Telecommunication Device for the Deaf(TDD), Diane Jenkins, (202) 452–3544,Board of Governors of the FederalReserve System, 20th Street andConstitution Avenue, NW, Washington,DC 20551.
FDIC: Robert F. Storch, Chief,Accounting Section, Division ofSupervision, (202) 898–8906; or JameyBasham, Counsel, Legal Division, (202)898–7265, Federal Deposit InsuranceCorporation, 550 17th Street, NW,Washington, DC 20429.
1 See 60 FR 17986 (April 10, 1995) (OCC); 60 FR8177 (February 13, 1995) (Board); 60 FR 15858(March 28, 1995) (FDIC).
Measurement and Capital Standards (July 1988).
4 For purposes of this discussion, references to‘‘securitization’’ also include structured financetransactions or programs that generally createstratified credit risk positions, which may or maynot be in the form of a security, whose performanceis dependent upon a pool of loans or other creditexposures.
5 As used in this proposal, the terms ‘‘creditenhancement’’ and ‘‘enhancement’’ refer to bothrecourse arrangements and direct credit substitutes.
against the amount of assets undermanagement in that securitization.
This proposal builds on the agencies’earlier work with respect to theappropriate risk-based capital treatmentfor recourse obligations and direct creditsubstitutes. On May 25, 1994, theagencies published in the FederalRegister a proposal to reduce the capitalrequirement for banks for low-levelrecourse transactions, to treat first-loss(but not second-loss) direct creditsubstitutes like recourse, and toimplement definitions of ‘‘recourse,’’‘‘direct credit substitute,’’ and relatedterms. 59 FR 27116 (May 25, 1994) (the1994 Notice). The 1994 Notice alsocontained, in an advance notice ofproposed rulemaking, a proposal to usecredit ratings to determine the capitaltreatment of certain recourse obligationsand direct credit substitutes. The OCC,the Board, and the FDIC subsequentlyimplemented the capital reduction forlow-level recourse transactions, therebysatisfying the requirements of section350 of the Riegle CommunityDevelopment and RegulatoryImprovement Act, Public Law 103–325,sec. 350, 108 Stat. 2160, 2242 (1994)(CDRI Act).1 The OTS risk-based capitalregulation already included the low-level recourse treatment required by thestatute.2 The agencies did not issue afinal regulation on the remainingelements of the 1994 Notice.
On November 5, 1997, the agenciespublished another notice of proposedrulemaking. 62 FR 59943 (1997Proposal). In the 1997 Proposal, theagencies proposed to use credit ratingsfrom nationally recognized statisticalrating organizations to determine thecapital requirement for recourseobligations, direct credit substitutes,and senior asset-backed securities.Additionally, the 1997 Proposalrequested comment on a series ofoptions and alternatives to supplementor replace the ratings-based approach.
qualifying external credit assessmentinstitutions as a basis for determiningthe credit quality and the resultingcapital treatment of securitizations.
which loans or other credit exposuresare pooled and reconstituted intosecurities, with one or more classes orpositions, that may then be sold.Securitization 4 provides an efficientmechanism for banking organizations tobuy and sell loan assets or creditexposures and thereby to make themmore liquid.
Securitizations typically carve up therisk of credit losses from the underlyingassets and distribute it to differentparties. The ‘‘first dollar,’’ orsubordinate, loss position is first toabsorb credit losses; the most ‘‘senior’’investor position is last; and there maybe one or more loss positions inbetween (‘‘second dollar’’ losspositions). Each loss position functionsas a credit enhancement for the moresenior loss positions in the structure.
For residential mortgages soldthrough certain Federally-sponsoredmortgage programs, a Federalgovernment agency or Federalgovernment sponsored enterprise (GSE)guarantees the securities sold toinvestors. However, many of today’sasset securitization programs involvenonmortgage assets or are not Federallysupported in any way. Sellers of theseprivately securitized assets thereforeoften provide other forms of creditenhancement—first and second dollarloss positions—to reduce investors’ riskof credit loss.
A seller may provide this creditenhancement itself through recoursearrangements. As defined in thisproposal, ‘‘recourse’’ refers to the risk ofcredit loss that a banking organizationretains in connection with the transferof its assets. Banking organizations havelong provided recourse in connectionwith sales of whole loans or loanparticipations; today, recoursearrangements frequently are associatedwith asset securitization programs.
enhancement is provided by anotherbanking organization, that organizationassumes some portion of the assets’credit risk. In this proposal, all forms ofthird-party enhancements, i.e., allarrangements in which a bankingorganization assumes risk of credit lossfrom third-party assets or other claimsthat it has not transferred, are referredto as ‘‘direct credit substitutes.’’ Theeconomic substance of a bankingorganization’s risk of credit loss fromproviding a direct credit substitute canbe identical to its risk of credit loss fromtransferring an asset with recourse.
Depending on the type ofsecuritization transaction, the sponsorof a securitization may provide aportion of the total credit enhancementinternally, as part of the securitizationstructure, through the use of spreadaccounts, overcollateralization, retainedsubordinated interests, or other similarforms of on-balance sheet assets. Whenthese or other types of internalenhancements are provided, theenhancements are considered a form ofrecourse for risk-based capital purposes.Many asset securitizations use acombination of internal enhancement,recourse, and third-party enhancementto protect investors from risk of creditloss.
While asset securitization canenhance both credit availability and abanking organization’s profitability,managing the risks associated with thisactivity can pose significant challenges.This is because the risks involved, whilenot new to banking organizations, maybe less obvious and more complex thanthe risks of traditional lending.Specifically, securitization can involvecredit, liquidity, operational, legal, andreputational risks in concentrations andforms that may not be fully recognizedby management or adequatelyincorporated into a bankingorganization’s risk managementsystems.
6 ‘‘Synthetic securitization’’ refers to the bundlingof credit risk associated with on-balance sheetassets and off-balance sheet items for subsequentsale into the market.
elaborate and formal approaches for assessing andmanaging the associated credit risk.
8 Stress testing usually involves identifyingpossible events or changes in market behavior thatcould have unfavorable effects on an bankingorganization and assessing the organization’s abilityto withstand them. Stress testing should not onlyconsider the probability of adverse events, but alsopotential ‘‘worst case’’ scenarios. Such an analysisshould be done on a consolidated basis andconsider, for example, the effect of higher thanexpected levels of delinquencies and defaults. Theanalysis should also consider the consequences ofearly amortization events that could raise concernsregarding a banking organization’s capital adequacyand its liquidity and funding capabilities. Stress testanalyses should also include contingency plansregarding the actions management might take givencertain situations.
9 Assets transferred with any amount of recoursein a transaction reported as a financing inaccordance with generally accepted accountingprinciples (GAAP) remain on the balance sheet andare risk-weighted in the same manner as any otheron-balance sheet asset. Assets transferred withrecourse in a transaction that is reported as a saleunder GAAP are removed from the balance sheetand are treated as off-balance sheet exposures forrisk-based capital purposes.
10 Consistent with statutory requirements, theagencies’ current rules also provide for specialtreatment of sales of small business loan obligationswith recourse. See 12 CFR Part 3, appendix A,Section 3(c) (OCC); 12 CFR parts 208 and 225,appendix A, II.B.5 (FRB); 12 CFR part 325,appendix A, II.B.6 (FDIC); 12 CFR 567.6(E)(3)(OTS).
11 Section 350 of the CDRI Act required theagencies to prescribe regulations providing that therisk-based capital requirement for assets transferredwith recourse could not exceed a bankingorganization’s maximum contractual exposure. Theagencies may require a higher amount if necessaryfor safety and soundness reasons. See 12 U.S.C.4808.
synthetic securitizations 6 using creditderivatives) and explicitly incorporatethe full range of risks into their riskmanagement systems. Management isresponsible for having adequate policiesand procedures in place to ensure thatthe economic substance of their risks isfully recognized and appropriatelymanaged. Banking organizations shouldbe able to measure and manage theirrisk exposure from risk positions in thesecuritizations, either retained oracquired, and should be able to assessthe credit quality of the retainedresidual portfolio after the transfer ofassets in a securitization transaction.The formality and