MORTGAGERELATED ASSETS

Capital Requirements 

Vary Depending on 

Type of Asset

Report to the Chairman, Committee on 

Banking, Housing, and Urban Affairs, 

U.S. Senate

December 2016

GAO-17-93

United States Government Accountability Office
United States Government Accountability Office

Highlights of GAO-17-93, a report to the 

Chairman, Committee on Banking, Housing, 

and Urban Affairs, U.S. Senate

December 2016

MORTGAGE-RELATED ASSETS

Capital Requirements Vary Depending on Type of 

Asset

What GAO Found

Rules for capital adequacy require banks to hold a percentage of their assets as 

capital to act as a financial cushion to absorb unexpected losses. Under current 

rules, banks must hold capital equal to at least 8 percent of risk-weighted assets. 

Since the early 1990s, U.S. federal banking regulators have used a riskweighting system under which banks multiply asset amounts by factors, known 

as risk weights, to calculate risk-weighted assets. Different types of assets have 

different risk weights that attempt to capture the assets’ relative risk. The Basel 

III-based final rule adopted in 2013 by the U.S. federal banking regulators 

incorporates higher risk weights for certain mortgage-related assets while leaving 

others unchanged from prior capital regimes (Basel I and Basel II). Most banks 

use the standardized approach for calculating risk-weighted assets, but large 

internationally active banks use an advanced approach that relies on formulas 

established by the regulators and inputs from their internal systems. 

• Under the standardized approach, the risk weights for single-family 

residential mortgages are largely unchanged by the final rule. Similarly, the 

risk weights under this approach for residential mortgage-backed securities 

(MBS) guaranteed by Ginnie Mae, Fannie Mae, and Freddie Mac have not 

changed since Basel I.

• Under the advanced approach, large internationally active banks use a 

formula defined in regulation to determine the capital requirements for 

residential mortgage exposures, which include whole loans as well as MBS 

guaranteed by Ginnie Mae, Fannie Mae, and Freddie Mac. This formula has 

not changed since it went into effect in 2008 under the Basel II-based rule.

• For both approaches, the ways for determining risk weights for securitization 

exposures and mortgage servicing assets have changed under the final rule, 

which may increase these risk weights. As required by the Dodd-Frank Wall 

Street Reform and Consumer Protection Act, the final rule eliminates the use 

of credit ratings for determining risk weights for securitization exposures, 

instead relying on regulator-established formulas. Also, the final rule reduces 

the cap on mortgage servicing assets that can be included in capital 

calculations and will raise the risk weight from 100 percent to 250 percent.

The Basel III-based final rule largely left in place the historically lower risk 

weights of MBS guaranteed by Fannie Mae and Freddie Mac vis-à-vis other 

mortgage-related assets, which can influence the demand for these securities 

relative to whole loans and privately issued MBS. However, the full impact of 

changes in risk weights for holdings of mortgage-related assets remains 

uncertain because insufficient time has passed since these changes took effect, 

and for some assets the changes have not yet been fully phased in. GAO’s 

recent work suggested that many lenders generally appeared to be participating 

in residential mortgage lending much as they had before capital requirements 

changed. Also, data on mortgage debt outstanding and on banks’ holdings of 

different assets indicate that trends in holdings of mortgage debt and mortgagerelated assets that predate the changes in risk weights have continued. But 

increased risk weights for some mortgage-related assets may lead to changes in 

banks’ decisions about securitizing and servicing mortgages. 

View GAO-17-93. For more information, 

contact Lawrance L. Evans, Jr. at (202) 512-

8678 or evansl@gao.gov.

Why GAO Did This Study

During the 2007–2009 financial crisis, 

many banking organizations lacked 

capital of sufficient quality and quantity 

to absorb substantial losses on 

mortgages and mortgage-related 

assets, revealing these assets to be 

riskier than previously thought. In 

response to the crisis, banking 

regulators around the world moved to 

strengthen requirements for capital 

adequacy. In the United States, the 

Dodd-Frank Wall Street Reform and 

Consumer Protection Act introduced, 

among other things, new capital 

requirements for bank holding 

companies and savings and loan 

holding companies. Internationally, in 

December 2010 the Basel Committee 

on Banking Supervision (which had 

issued the Basel I and Basel II 

frameworks) issued the Basel III 

framework—a comprehensive set of 

reforms to strengthen global capital 

and liquidity standards—with the goal 

of promoting a more resilient banking 

sector. Under this framework, banks 

apply risk weights to different assets to 

determine the amount of capital they 

need to meet regulatory requirements.

GAO was asked to explain how capital 

requirements for a mortgage depend 

upon how it is financed and how the 

requirements have changed since the 

crisis. This report examines the risk 

weights for residential mortgages and 

certain other mortgage-related assets 

under the U.S. Basel III-based rule and 

how they compare to those in effect 

under prior capital regimes and for 

nonbank entities. GAO examined 

information on capital requirements 

from current and past rules.

GAO received technical comments 

from the banking regulators, which 

were incorporated as appropriate.
Page i GAO-17-93 Capital Requirements

Letter 1

Background 3

The Basel III-Based Final Rule Changes the Risk Weights for 

Some Mortgage-Related Assets 7

Agency Comments 22

Appendix I Calculation of Risk-Weighted Assets for Retail Exposures under the 

Advanced Internal Ratings-Based Approach 24

Appendix II Specification of the Simplified Supervisory Formula Approach 27

Appendix III GAO Contact and Staff Acknowledgments 30

Tables

Table 1: Risk Weights for Selected Mortgage-Related Assets Held 

by Banks under Different Capital Regimes 7

Table 2: Risk Weights for Hypothetical Securitization Structure 

Using the Simplified Supervisory Formula Approach 13

Table 3: Nonbank Mortgage Servicer Capital and Liquidity 

Requirements 18

Figure Figure 1: Volume of Mortgage Debt Outstanding by Holder or 

 Guarantor, 2011 through Second Quarter 2016 20

Contents
Page ii GAO-17-93 Capital Requirements

Abbreviations

Basel Committee Basel Committee on Banking Supervision

bps basis points

Dodd-Frank Act Dodd-Frank Wall Street Reform and Consumer 

Protection Act

EAD exposure at default

FDIC Federal Deposit Insurance Corporation

Federal Reserve Board of Governors of the Federal Reserve System

LGD loss given default

MBS mortgage-backed securities

NPL nonperforming loans

NRSRO nationally recognized statistical rating organizations

OCC Office of the Comptroller of the Currency

PD probability of default

SFA supervisory formula approach

SSFA simplified supervisory formula approach

UPB unpaid principal balance

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Page 1 GAO-17-93 Capital Requirements

441 G St. N.W.

Washington, DC 20548

December 15, 2016

The Honorable Richard Shelby

Chairman

Committee on Banking, Housing, and Urban Affairs

United States Senate

Dear Mr. Chairman:

During the 2007–2009 financial crisis, many banking organizations lacked 

capital of sufficient quality and quantity to absorb substantial losses, 

specifically on mortgages and mortgage-related assets, revealing these 

assets to be riskier than previously thought. In response to the crisis, 

banking regulators around the world moved to strengthen requirements 

for capital adequacy. In the United States, the 2010 Dodd-Frank Wall 

Street Reform and Consumer Protection Act (Dodd-Frank Act) required, 

among other things, that the U.S. federal banking regulators develop new 

capital requirements for bank holding companies, savings and loan 

holding companies, and banks.1 At about the same time, at the 

international level, in December 2010 the Basel Committee on Banking 

Supervision (Basel Committee) issued the Basel III framework—a 

comprehensive set of reforms to strengthen global capital and liquidity 

standards—with the goal of promoting a more resilient banking sector.2 In 

2013 and 2014, the U.S. federal banking regulators adopted rules to 

implement many aspects of the Basel III capital framework that apply to 

banks, savings associations, and top-tier U.S. bank and savings and loan 

holding companies (with certain exceptions). These rules, commonly 

 1

Pub. L. No. 111-203, § 171, 124 Stat. 1376, 1435. 

2

Basel Committee on Banking Supervision, Basel III: A Global Regulatory Framework for 

More Resilient Bank and Banking Systems (Basel, Switzerland: December 2010, revised 

June 2011). The Basel Committee is an international standard-setting body that comprises 

representatives of central banks and banking regulators from 27 countries and deals with 

various aspects of bank supervision.

Letter
Page 2 GAO-17-93 Capital Requirements

referred to as the Basel III capital requirements, are generally being 

phased in by 2019.3

You asked us to explain how the capital requirements for a typical 

mortgage depend upon how the loan is financed (i.e., whole loan, lender 

recourse, single-class MBS, credit risk transfer, PLS, FHA, REMIC, etc.) 

and compare these capital requirements to those in place before the 

financial crisis. This report examines the risk weights—that is, the weights 

(or factors) used to calculate the amount of capital needed to meet 

regulatory requirements—for mortgages and other mortgage-related 

assets under the U.S. Basel III capital requirements and how they 

compare to those in effect under prior capital regimes and for nonbank 

entities holding mortgage-related assets.

To address this objective, we reviewed and analyzed the banking 

agencies’ final rules implementing various regulatory capital regimes and 

relevant literature on bank capital regulation, including academic studies 

and research by industry organizations, federal agencies, and others with 

a focus on bank regulatory capital and the assignment of risk weights to

mortgages and mortgage-related exposures. Additionally, we analyzed 

sections of the Dodd-Frank Act that restricted the use of external credit 

ratings in setting regulatory capital in the United States. We also reviewed 

financial accounting standards to understand impacts of capital 

requirements on banks’ willingness to engage in securitization of 

mortgage assets. Furthermore, we reviewed our prior reports and reports 

by the Basel Committee and the Congressional Research Service on 

capital requirements, including those for the housing governmentsponsored enterprises Fannie Mae and Freddie Mac (the enterprises) 

and nonbank financial institutions, to better understand differences in 

capital requirements that may affect institutions’ decisions related to 

 3

For rules issued by the Department of the Treasury’s Office of the Comptroller of the 

Currency (OCC) and the Board of Governors of the Federal Reserve System (Federal 

Reserve), see 78 Fed. Reg. 62,018 (Oct. 11, 2013) (final rule). For rules issued by the 

Federal Deposit Insurance Corporation (FDIC), see 78 Fed. Reg. 55,340 (Sept. 10, 2013) 

(interim final rule) and 79 Fed. Reg. 20,754 (Apr. 14, 2014) (final rule). 
Page 3 GAO-17-93 Capital Requirements

mortgage-related assets.4 We also reviewed data from the Board of 

Governors of the Federal Reserve System (Federal Reserve) on 

mortgage debt outstanding and from SNL Financial, which provides 

comprehensive regulatory financial data on financial institutions, on

banks’ holdings of mortgage-related assets to observe trends in holdings 

of mortgage-related assets. We assessed the reliability of both data 

sources by reviewing information about the data and systems that 

produced them, comparing the data to other published sources, and by 

reviewing assessments we did for previous studies. We determined that 

the data we used remains sufficiently reliable for the purposes of our 

reporting objectives. Finally, we interviewed market participants, including 

officials at the Mortgage Bankers Association, to obtain additional insights 

into changes in capital requirements.

We conducted this performance audit from May 2016 to December 2016 

in accordance with generally accepted government auditing standards. 

Those standards require that we plan and perform the audit to obtain 

sufficient, appropriate evidence to provide a reasonable basis for our 

findings and conclusions based on our audit objectives. We believe that 

the evidence obtained provides a reasonable basis for our findings and 

conclusions based on our audit objectives.

Bank capital performs several important functions. Among other things, 

capital acts as a financial cushion to absorb unexpected losses, promotes 

public confidence in the solvency of the institution and the stability of the 

banking sector, and provides protection to depositors and deposit 

insurance funds. Because of capital’s role in absorbing losses, promoting 

confidence, and protecting depositors, federal banking regulations require 

banking organizations to maintain adequate capital, and regulators set 

 4

See, for example, GAO, Mortgage Servicing: Community Lenders Remain Active under 

New Rules, but CFPB Needs More Complete Plans for Reviewing Rules, GAO-16-448 

(Washington, D.C.: June 23, 2016) and Bank Capital Reforms: Initial Effects of Basel III on 

Capital, Credit, and International Competitiveness, GAO-15-67 (Washington, D.C.: Nov. 

20, 2014); Basel Committee on Banking Supervision, Basel II: International Convergence 

of Capital Measurement and Capital Standards: A Revised Framework (Basel, 

Switzerland: June 2004) and International Convergence of Capital Measurement and 

Capital Standards (Basel, Switzerland: July 1988); and Congressional Research Service, 

Overview of the Prudential Regulatory Framework for U.S. Banks: Basel III and the DoddFrank Act, R44573 (Washington, D.C.: July 27, 2016).

Background
Page 4 GAO-17-93 Capital Requirements

minimum capital levels to help ensure that institutions do so, including a 

target total minimum risk-based capital ratio—that is, the ratio of capital to 

risk-weighted assets. Federal law authorizes banking regulators to take a 

variety of actions to ensure capital adequacy, including informal and 

formal enforcement actions. Federal banking regulators generally expect 

institutions to hold capital at levels higher than regulatory minimums.

Capital rules in the United States generally follow a framework of 

measures adopted by the Basel Committee. U.S. federal banking 

regulators have adopted various risk-based capital regimes over the past 

decades. Under these frameworks, assets and off-balance-sheet 

exposures are assigned to one of several broad risk categories according 

to the obligor (for example, the person or legal entity contractually 

obligated on an exposure), or if relevant, the guarantor or the nature of 

the collateral.5 Banking organizations multiply the aggregate dollar 

amount or exposure amount in each risk category by the risk weight 

associated with that category. The resulting risk-weighted amounts from 

each of the risk categories are added together, and generally this sum is 

the banking organization’s total risk-weighted assets, which comprises 

the denominator of the risk-based capital ratio. For example, a $1,000 onbalance-sheet asset at a 20 percent risk weight would equal $200 in riskweighted assets. An additional $1,000 on-balance-sheet asset at a 50 

percent risk weight would equal $500 in risk-weighted assets, for a total of 

$700 in risk-weighted assets (compared to the $2,000 in total assets). 

The risk weights enable one to calculate the amount of capital a banking 

organization would need to hold for a given asset—its “capital charge”—in 

order to meet the minimum risk-based capital ratio requirements. To meet 

an 8 percent minimum total capital ratio requirement, the organization 

with the $700 in risk-weighted assets in the previous example would need 

to hold $56 in capital ($700×0.08). The minimum total capital charge for 

 5

Off-balance-sheet exposures are activities that are not recognized on the banks’ balance 

sheet but are effectively assets or liabilities of the bank. These exposures can include 

commitments (which are legally binding arrangements that obligate a banking organization 

to extend credit or purchase assets), guarantees (which are financial instruments that 

allow one party to transfer credit risk of one or more specific exposures to another party), 

and repurchase agreements, among others. Banks must apply credit conversion factors 

specified by the banking regulators to off-balance-sheet exposures in order to convert the 

exposure amounts to on-balance-sheet equivalent amounts. The risk weights are then 

applied to the on-balance-sheet equivalent amounts to calculate risk-weighted assets and 

minimum capital requirements.
Page 5 GAO-17-93 Capital Requirements

the $1,000 on-balance-sheet asset that was risk-weighted at 20 percent 

would be $16 ($1,000×0.2×0.08), while the minimum capital charge for 

the $1,000 on-balance-sheet asset that was risk-weighted at 50 percent 

would be $40 ($1,000×0.5×0.08).

Risk weights for mortgages and other mortgage-related assets have been 

included in a number of these regulatory capital frameworks over the 

years, including the following:

• The Basel Capital Accord (Basel I), which was adopted in 1988 and 

implemented in the United States in the early 1990s, established a 

system of generally applicable risk weights for specific assets 

(including mortgage-related assets) to calculate total risk-weighted 

assets and defined a minimum total risk-based capital ratio (the ratio 

of regulatory capital to risk-weighted assets) of 8 percent with limited 

exceptions. Under this system, all assets of a certain category—for 

example, commercial loans—were assigned a flat risk weight without 

regard for differences in credit quality among the assets in that 

category (simple risk-bucket approach). Asset categories were 

classified into one of four risk-weight buckets—0 percent, 20 percent, 

50 percent, or 100 percent.

• Amendments to the U.S. federal banking regulators’ rules adopted in 

2001 implemented a multilevel, ratings-based approach to assess 

capital requirements on asset securitizations— including mortgagebacked securities (MBS)—based on their relative exposure to credit 

risk.6 The approach used credit ratings from nationally recognized 

statistical rating organizations (NRSRO) to measure relative exposure 

to credit risk and determine the associated risk-based capital 

requirement.7

• In 2007, U.S. federal banking regulators adopted capital rules for 

large internationally active banking organizations that were based on 

a revised framework published by the Basel Committee in 2006 

 6

When assets (such as mortgages) are securitized, they are pooled together into a 

security, and the payment streams associated with the assets are sold to investors. 

7

A credit rating is an assessment of the creditworthiness of an obligor as an entity or in 

relation to specific securities or money market instruments. 15 U.S.C. § 78c(a)(60). The 

Securities and Exchange Commission first used the term “Nationally Recognized 

Statistical Rating Organization” in 1975 to describe those rating agencies whose ratings 

could be relied upon to determine capital charges for different types of debt securities. 
Page 6 GAO-17-93 Capital Requirements

(Basel II).8 Only large, internationally active banks—banks with 

consolidated total assets (excluding assets held by an insurance 

underwriting subsidiary of a bank holding company) of $250 billion or 

more or with consolidated total on-balance-sheet foreign exposure of 

$10 billion or more—were required to adopt the advanced approaches 

for measuring risk (including mortgage-related credit risk) established 

in the Basel II-based rules. Under these rules, the advanced internal 

ratings-based approach used risk parameters determined by a bank’s 

internal systems as inputs into a formula developed by supervisors for 

calculating minimum regulatory capital and expanded the use of credit 

ratings to measure credit risk.9

• U.S. federal banking regulators promulgated a final rule in 2013 to 

incorporate many of the changes included in the Basel III 

framework.10 Among other changes, the final rule includes a new 

standardized approach for credit risk to replace the Basel I generally 

applicable risk-based capital rule. The final rule also removed 

references to credit ratings that were in the Basel I generally 

applicable rule and the advanced internal ratings-based approach, 

consistent with requirements in Section 939A of the Dodd-Frank Act.11

Other entities that hold mortgages and mortgage-related assets have 

different capital requirements. For example, in 1992 the Office of Federal 

Housing Enterprise Oversight, which at the time was the regulator for the 

enterprises, adopted minimum capital requirements based on the 

enterprises’ on-balance-sheet assets and off-balance-sheet obligations. 

Nonbank financial institutions that service mortgages for the enterprises 

and Ginnie Mae must comply with minimum capital and net worth 

requirements those entities have issued.

 8

Basel Committee on Banking Supervision, International Convergence of Capital 

Measurement and Capital Standards: A Revised Framework (Basel, Switzerland: June 

2006).

9

Another advanced approach included in the rules is the advanced measurement 

approach, which is used to measure operational risk and is not discussed in this report.

10We described a number of other changes to capital requirements brought about by 

Basel III and the U.S. banking regulators’ final rule in a 2014 report. See GAO-15-67.

11For the purposes of this report, we refer to the ratings-based approach as credit ratingsbased approach to distinguish between it and the advanced internal ratings-based 

approach. Regulatory capital frameworks and rules do not use “credit ratings-based 

approach.”
Page 7 GAO-17-93 Capital Requirements

The Basel III final rule adopted in 2013 by the U.S. federal banking 

regulators and generally effective as of January 2015 incorporates higher 

risk weights for certain mortgage-related exposures while leaving others 

unchanged (see table 1). For example, the risk weights for most singlefamily residential mortgages are largely unchanged by the final rule. 

However, the final rule changed the risk weights for some mortgagerelated securitization exposures and for mortgage servicing assets.

Table 1: Risk Weights for Selected Mortgage-Related Assets Held by Banks under Different Capital Regimes

Asset

Basel I-based rulea

(1992–2014)

(percent)

Basel II-based rulea

(2008–2014)

(percent)

Basel III-based ruleb

Standardized

(2015–present)

(percent)

Advanced

(2014–present)

(percent)

Single-family residential 

mortgages – not 

guaranteed by U.S. 

government agencies

50 or 100c Determined by a formula defined 

by regulators for retail exposures 

using, among other 

considerations, estimates of the 

probability of default and loss 

given default derived from banks 

internal systemsd

Same as Basel I Same as Basel II

Ginnie Mae residential 

mortgage-backed 

securities (MBS)

0 Same as above Same as Basel I Same as Basel II

Fannie Mae and 

Freddie Mac passthrough residential MBS 

20 Same as above Same as Basel I Same as Basel II

Securitization 

exposurese If externally rated, 20 to 200 based on long-term credit ratings 

one category below investment 

grade or betterf

For unrated recourse obligations 

and direct credit substitutes, 20% 

to 1,250% using the gross-up 

approachg or deducted from 

capital

If externally rated, 7 to 650 based 

on long-term credit ratings one 

category below investment grade

or betterf

and other factors

If unrated, determined by

supervisory formula approach 

(SFA)h or deducted from capital

20 to 1,250 

based on

simplified 

supervisory 

formula approach 

(SSFA)ior grossup approachg

20 to 1,250 

based on SFAh

or SSFAi

Mortgage servicing 

assets

100 Same as Basel I 250j 250j

Source: GAO analysis of regulations. | GAO-17-93

a

Only large internationally active banks were subject to the Basel II-based rule. These banking 

organizations were those that (a) had consolidated assets equal to $250 billion or more, (b) had

consolidated total on-balance sheet foreign exposures equal to $10 billion or more, or (c) were 

subsidiaries of a bank or holding company required to use the Basel II-based rule. All other banks 

continued to follow the Basel I-based rule until the Basel III-based rule went into effect. From 2008 to 

2011, the large internationally active banks had to apply the advanced internal ratings-based 

approach introduced in the Basel II-based rule for calculating risk weights and capital requirements. 

In 2011, the U.S. federal banking regulators required these banks to also use the generally applicable 

risk-based capital framework from the Basel I-based rule as a floor for calculating minimum capital 

requirements.

The Basel III-Based 

Final Rule Changes 

the Risk Weights for

Some MortgageRelated Assets
Page 8 GAO-17-93 Capital Requirements

b

Under the Basel III-based rule, the standardized approach replaces the generally applicable riskbased capital framework from the Basel I-based rule for all banks. The Basel III-based rule also 

continues use of the advanced internal ratings-based approach from the Basel II-based rule (with 

some changes) for large internationally active banks.

c

First-lien residential mortgage loans that are secured by a property that is owner-occupied or rented, 

made in accordance with prudent underwriting standards, not 90 days or more past due or carried in 

nonaccrual status, and not restructured or modified exempt solely pursuant Treasury’s Home 

Affordable Mortgage Program qualify for the 50 percent risk weight.

d

Retail exposures include most credit exposures to individuals (including residential mortgages) and 

small credit exposures to businesses that are managed as part of a segment of exposures with 

similar risk characteristics and not managed on an individual-exposure basis. The probability of 

default for a segment of non-defaulted retail exposures is a banking organization’s empirically based 

best estimate of the long-run average one-year default rate for the exposures in the segment. The 

loss given default for a segment of retail exposures includes a banking organization’s empirically 

based best estimate of the long-run default-weighted average economic loss the banking organization 

would expect to incur if the exposures in the segment were to default within a 1 year horizon during 

economic downturn conditions.

e

The Basel I-based rule specified how to calculate risk weights for a number of different securitization 

exposures, including direct credit substitutes, recourse obligations, and residual interests. The Basel 

II-based rule defined securitization exposures as exposures that, among other requirements, arise 

from transactions in which the credit risk associated with the underlying exposures has been 

separated into at least two tranches reflecting different levels of seniority. This definition was also 

included in the Basel III-based rule.

f

Exposures rated more than one category below investment grade must be deducted from total 

capital—essentially equivalent to a risk weight of 1,250 percent.

g

The gross-up approach involves calculating an amount of capital for the bank’s exposure as well as 

for the portion of more senior exposures, if any, for which the bank’s exposure provides support.

h

SFA requires banks to calculate several input parameters on an ongoing basis, including the 

exposure’s credit enhancement level and thickness and the capital requirements for the underlying 

exposures.

i

SSFA takes into account the weighted average capital charge for the underlying exposures, 

delinquency level of the underlying collateral, and the relative size and seniority of the security in the 

securitization structure.

j

Effective January 1, 2018.

Risk weights for residential first-lien mortgages on one-to-four family 

properties that are held in banks’ portfolios have remained largely 

unchanged since the adoption of the Basel I-based rules. Under the 

standardized approach outlined in the Basel III-based final rule, the 

portions of mortgages that are conditionally guaranteed by U.S. 

government agencies, such as the Federal Housing Administration or the 

Department of Veterans Affairs, are assigned 20 percent risk weights 

under the standardized approach—essentially unchanged since Basel I. 

Other mortgages—and the portions of mortgages not guaranteed by U.S. 

government agencies—secured by one-to-four family residential 

properties are assigned a 50 percent risk weight, provided that such loans 

are:

• secured by a property that is either owner-occupied or rented;

Overall Risk Weights for 

Mortgages Remain 

Largely Unchanged
Page 9 GAO-17-93 Capital Requirements

• made in accordance with prudent underwriting standards, including 

standards relating to the loan amount as a percentage of the 

appraised value of the property;

• not 90 days or more past due or carried in nonaccrual status; and

• not restructured or modified (other than through the Department of the 

Treasury’s Home Affordable Modification Program).

Also, if a banking organization holds the first-lien and junior-lien 

residential mortgage exposures, and no other party holds an intervening 

lien, the institution must combine the exposures and treat them as a 

single loan secured by a first lien to determine the loan-to-value ratio and 

assign a risk weight.12 Banking organizations are required to assign a 100 

percent risk weight to a first-lien residential mortgage exposure that does 

not meet the criteria previously listed and to junior-lien residential 

mortgage exposures if the banking organization does not hold the first 

lien on the property.

The advanced internal ratings-based approach requires banking 

organizations to use a formula defined in regulation to determine the 

capital requirements for residential mortgage exposures, which are 

grouped into segments that have similar (homogeneous) risk 

characteristics. The formula for the capital charge for nondefaulted 

residential mortgage exposures uses values for the probability of default 

and loss given default that each bank derives from its internal systems 

(see app. I).13 For example, applying a probability of default of 3 percent

and losses given default of 20 percent to a segment of nondefaulted 

residential mortgages would result in a risk weight of about 50 percent 

using this formula. This formula is unchanged since it went into effect in 

2008.

 12A junior lien is a loan that uses the same property as an existing loan (first lien) as 

collateral and is subordinate to the existing loan. Home equity loans and home equity lines 

of credit are common examples of junior liens.

13The probability of default for a segment of non-defaulted retail exposures is a banking 

organization’s empirically based best estimate of the long-run average one-year default 

rate for the exposures in the segment. The loss given default for a segment of retail 

exposures includes a banking organization’s empirically based best estimate of the longrun default-weighted average economic loss the banking organization would expect to 

incur if the exposures in the segment were to default within a 1 year horizon during 

economic downturn conditions.
Page 10 GAO-17-93 Capital Requirements

Under this advanced approach, defaulted residential mortgage exposures 

that are covered by an eligible U.S. government guarantee have a capital 

charge of 1.6 percent for the portion that is covered by the guarantee—an 

implicit 20 percent risk weight (0.016 ÷ 0.08 = 0.2).14 The previous rules 

did not include a separate provision for defaulted residential mortgage 

exposures covered by a government guarantee. Defaulted residential 

mortgage exposures not covered by an eligible U.S. government 

guarantee have a capital charge of 8 percent, which implies a risk weight 

of 100 percent.

The standardized approach and the advanced approach both assign a 

risk weight of 50 percent to pre-sold construction loans with a legally 

binding sales contract unless the purchase contract is cancelled, in which 

case a banking organization must assign a 100 percent risk weight.15

The Basel III-based final rule keeps the risk weights for government- and 

enterprise-guaranteed MBS outlined under the previous rules but 

changes how the risk weights for private-label securities are calculated.16

Under the standardized approach, residential MBS guaranteed by Ginnie 

Mae have a risk weight of 0 percent, while residential MBS issued and 

guaranteed by Fannie Mae and Freddie Mac have a risk weight of 20 

percent—unchanged since Basel I.17 As shown previously in table 1, risk 

weights for other MBS that qualify as securitization exposures can range 

 14Eligible guarantees are written guarantees that either are unconditional or are 

contingent obligations of the U.S. government or its agencies, the enforceability of which 

is dependent upon some affirmative action on the part of the beneficiary of the guarantee 

or a third party (for example, meeting servicing requirements).

15A pre-sold construction loan is a one-to-four family residential construction loan to a 

builder that, among other requirements, is made in accordance with prudent underwriting 

standards, where the purchaser is an individual who intends to occupy the residence, has 

entered into a legally binding written sales contract for the residence, and has made an 

earnest money deposit of at least 3 percent of the sales price that is being held in escrow. 

In addition, the builder must incur at least the first 10 percent of the direct costs of 

construction of the residence before any drawdown is made under the loan, which may 

not exceed 80 percent of the sales price of the presold residence.

16Private-label securities are securities that are not issued or guaranteed by a federal 

government agency or the enterprises.

17Under the advanced approach, these MBS are treated as residential mortgage 

exposures and included in the formula described previously.

Some Risk Weights for 

Mortgage-Related 

Securitization Exposures 

Changed under the Final 

Rule
Page 11 GAO-17-93 Capital Requirements

from 20 percent to 1,250 percent under either the standardized or the 

advanced approaches.18 Previously, risk weights for securitization 

exposures could be as low as 7 percent under the advanced approach. 

Under the current rules, banks using the advanced internal-ratings based 

approach must also apply the standardized approach. If banks are unable 

to use the formulas and approaches defined in the final rule for the 

standardized and advanced approaches—for example, because they do 

not have data to calculate all the inputs—they must apply the 1,250 

percent risk weight to their securitization exposures.

The Basel III final rule establishes two methods for calculating risk 

weights for securitization exposures under the standardized approach:

• The simplified supervisory formula approach relies on objective inputs 

to calculate risk weights for securitization exposures using a formula. 

To use this approach, a bank needs to know the performance of the 

underlying assets.

• The “gross-up” approach involves calculating an amount of capital for 

the bank’s exposure as well as for the portion of more senior 

exposures (that is, the least risky tranches, which are given priority for 

repayment), if any, for which the bank’s exposure provides support. If 

a bank does not have access to the inputs required to calculate the 

simplified supervisory formula approach, or prefers a simpler 

approach, the gross-up approach can be applied.

 18A securitization exposure is an on-balance-sheet or off-balance-sheet credit exposure 

that arises from a transaction in which the credit risk associated with the underlying 

exposures has been separated into at least two tranches reflecting different levels of 

seniority; performance of the securitization exposures depends upon the performance of 

the underlying exposures; and all or substantially all of the underlying exposures are 

financial exposures. Such a transaction can be a traditional securitization, in which the 

underlying credit risk of one or more underlying exposures is transferred to one or more 

third parties other than through the use of credit derivatives or guarantees, or a synthetic 

securitization, in which all or a portion of the credit risk of one or more underlying 

exposures is retained or transferred to one or more third parties through the use of one or 

more credit derivatives or guarantees. See 12 C.F.R. § 3.2 (OCC); 12 C.F.R. § 217.2 

(Federal Reserve); 12 C.F.R. § 324.2 (FDIC).

Securitization Exposure 

Calculations under the 

Standardized Approach
Page 12 GAO-17-93 Capital Requirements

Banks that are subject to another rule, the market risk rule, must use the 

simplified supervisory formula approach.19 Banks that are not subject to 

this other rule may choose to use either method but must use the same 

method across all exposures.

Simplified Supervisory Formula Approach

The simplified supervisory formula approach takes into account the 

weighted average capital charge for the underlying exposures, 

delinquency level of the underlying collateral, and the relative size and 

seniority of the security in the securitization structure (see app. II for the 

details of the formula). The current balances of all the underlying 

exposures in the securitization structure are used to calculate the 

attachment and detachment points for each level, or tranche, of the 

structure.20 Losses are first borne by the lowest tranches. Once a tranche 

experiences a total loss, the next tranche immediately senior to it begins 

to bear any additional losses.

The following hypothetical securitization structure illustrates the simplified 

supervisory formula approach for a securitization backed by a pool of 

residential mortgages that would be risk-weighted at 50 percent. For such 

a securitization, the typical capital charge of the underlying mortgage pool 

is 4 percent (50 percent risk weight multiplied by 8 percent minimum riskbased capital ratio). Assuming that 5 percent of the mortgages in the pool 

are delinquent and have a risk weight of 100 percent (for an 8 percent 

capital charge), the weighted average capital charge of the mortgage pool 

would be 4.2 percent.21 The risk weights for each of the tranches can be 

 19The market risk rule is outlined in subpart F of the banking regulators’ Basel III-based 

final rule and applies to any banking organization with aggregate trading assets and 

trading liabilities equal to 10 percent or more of quarter-end total assets (as reported on 

the most recent quarterly report) or $1 billion or more. 

20A tranche is defined by attachment and detachment points. The attachment point is the 

position of the tranche in the deal structure where the tranche begins to experience 

losses. It is the percentage of the total securitization pool subordinated to that tranche. 

The detachment point is the position of the tranche in the deal structure where credit 

losses result in a complete loss of principal. 

21With 95 percent of the pool having a capital charge of 4 percent, and 5 percent of the 

pool having a capital charge of 8 percent, the weighted average capital charge is (0.95 × 

0.04) + (0.05 × 0.08) = 0.042 (4.2 percent).
Page 13 GAO-17-93 Capital Requirements

calculated using the formula outlined in the final rule and described in 

appendix II. The risk-weight results for a pool that does not involve 

resecuritizations are shown in table 2.22 If 10 percent of the underlying 

mortgage pool is delinquent, the weighted average capital charge would 

be 4.4 percent, and the tranche risk weights for the lower (more risky) 

tranches would increase, reflecting the increased likelihood of losses on 

these tranches.23 In both scenarios, the most senior tranches would have 

risk weights of 20 percent.

Table 2: Risk Weights for Hypothetical Securitization Structure Using the Simplified Supervisory Formula Approach

Risk weights with

Tranche Type

Balance

(dollars)

5 percent of underlying 

mortgages delinquent

(percent)

10 percent of underlying 

mortgages delinquent

(percent)

A1 Senior 50,000,000 20 20

A2 Senior 300,000,000 20 20

B Mezzanine 50,000,000 20 43

C Mezzanine 50,000,000 131 396

SUBORD Junior 49,000,000 1,076 1,236

Overcollateralization/cash reserves 1,000,000 1,250 1,250

Total 500,000,000

Source: GAO analysis using the Federal Deposit Insurance Corporation’s Simplified Supervisory Formula Approach Tool. | GAO-17-93

Note: The hypothetical securitization structure does not involve resecuritizations. The mezzanine 

tranches are subordinated to the senior tranches, but are senior to the junior tranche. The senior 

tranches are the least risky tranches, whereas the junior tranche is the first loss (after cash reserves) 

and riskiest tranche.

Risk weights for other securitization exposures, such as real estate 

mortgage investment conduits, can also be calculated using the simplified 

supervisory formula approach.24 Similarly, the credit risk transfer 

 22A resecuritization is defined as a securitization which has more than one underlying 

exposure and in which one or more of the underlying exposures is a securitization 

exposure.

23The risk weights calculated using the formula would increase for all tranches. However, 

the regulators established a supervisory floor of 20 percent for securitization exposures, 

which overrides the risk weights below 20 percent.

24A real estate mortgage investment conduit is an entity that issues multiple classes (or 

tranches) of interests in a type of MBS backed by mortgages or MBS that is structured to 

meet certain criteria for tax purposes. 
Page 14 GAO-17-93 Capital Requirements

transactions the enterprises have engaged in with various investors would 

be treated as securitization exposures for banks that hold these notes. In 

most cases, these notes would have risk weights at or near 1,250 percent 

due to the holders of the notes being in or near the first-loss position.

Previously, under the Basel I-based rules that most banks were subject to 

through 2014, some private-label securitization exposures were assigned 

general risk weights while others were given risk weights based on credit 

ratings. For example, privately issued MBS backed by mortgages that 

would qualify for the 50 percent risk weight would receive a 50 percent 

risk weight, subject to certain conditions.25 Mortgage securitization 

exposures—including direct credit substitutes, recourse, and residual 

interests—that were externally rated were assigned risk weights between 

20 percent (for long-term credit ratings of AAA or AA) and 200 percent 

(for BB ratings, which indicate higher risk).26

 25MBS had to meet the following conditions to qualify for the 50 percent risk weight: (1) 

the underlying assets had to be held by an independent trustee that had a first priority, 

perfected security interest in the underlying assets for the benefit of the holders of the 

security; (2) the holder of the security had to have an undivided pro rata ownership 

interest in the underlying assets or the trust that issued the security had to have no 

liabilities unrelated to the issued securities; (3) the trust that issued the security had to be 

structured such that the cash flows from the underlying assets fully met the cash flow 

requirements of the security without undue reliance on any reinvestment income; and (4) 

there could not be any material reinvestment risk associated with any funds awaiting 

distribution to the holder of the security. See 12 C.F.R. pt. 3 app. A (2013).

26A direct credit substitute is an arrangement in which a bank assumes, in form or in 

substance, credit risk associated with an on- or off-balance-sheet asset or exposure that 

was not previously owned by the bank and the risk assumed by the bank exceeds the pro 

rata share of the bank’s interest in the third-party asset. If a bank has no claim on the 

third-party asset, then the bank’s assumption of any credit risk is a direct credit substitute. 

Recourse obligations from securitizations are a bank’s retention, in form or in substance,

of any credit risk directly or indirectly associated with an asset it has sold that exceeds a 

pro rata share of that bank’s claim on the asset. If a bank has no claim on a sold asset, 

then the retention of any credit risk is recourse. A recourse obligation typically arises when 

a bank transfers assets and retains an explicit obligation to repurchase assets or to 

absorb losses due to a default on the payment of principal or interest or any other 

deficiency in the performance of the underlying obligor or some other party. Recourse may 

also exist implicitly if a bank provides credit enhancement beyond any contractual 

obligation to support assets it has sold. A residual interest is any on-balance-sheet asset 

that represents an interest created by a transfer that qualifies as a sale of financial assets, 

whether through a securitization or otherwise, and that exposes a bank to any credit risk 

directly or indirectly associated with the transferred asset that exceeds a pro rata share of 

that bank’s claim on the asset, whether through subordination provisions or other credit 

enhancement techniques. See 12 C.F.R. pt. 3 app. A (2016).
Page 15 GAO-17-93 Capital Requirements

Gross-up Approach

The gross-up approach in the Basel III-based rule is the same as an 

approach that was available under the previous rules. To calculate riskweighted assets under the gross-up approach, a banking organization 

determines three inputs along with the exposure amount: the pro rata 

share, the enhanced amount, and the applicable risk weight.

• The pro rata share is the par value of the banking organization’s 

exposure as a percentage of the par value of the tranche in which the 

securitization exposure resides—for example, a $5,000 exposure in a 

$10,000 junior tranche of one-to-four family residential mortgages 

would be a 50 percent pro rata share.

• The enhanced amount is the par value of all tranches that are more 

senior to the tranche in which the exposure resides. These more 

senior tranches are “enhanced”—that is, their credit profiles are 

improved by—the subordinated tranches. If the total securitization in 

the previous example is $100,000, the par value of all tranches that 

are more senior to the tranche in which the bank has an interest is 

$90,000.

• The applicable risk weight is the weighted-average risk weight of the 

underlying exposures in the securitization as calculated under the 

standardized approach. For mortgages not guaranteed by the federal 

government (as in the previous example), the underlying exposures 

can have risk weights of either 50 percent or 100 percent. The 

weighted-average risk weight would be 75 percent if half of the total 

amount of underlying mortgages had a risk weight of 50 percent and 

the remaining underlying exposures had a risk weight of 100 percent.

For the previous example, assume the weighted-average risk weight of 

the underlying exposures is 50 percent (that is, all the mortgages meet all 

of the requirements discussed previously, such as not 90 days past due 

and not restructured or modified). The risk weight would then be applied 

to the bank’s interest—$5,000—plus the pro rata share of the more senior 

tranches—50 percent of $90,000. In other words, $50,000 ($5,000 plus 

$45,000) would be multiplied by the 50 percent risk weight. The result, 

$25,000, is equivalent to a 500 percent risk weight on the bank’s $5,000 

exposure. The bank would then multiply the $25,000 by the minimum 

capital requirement of 8 percent to determine that the capital requirement 

for the $5,000 exposure is $2,000.
Page 16 GAO-17-93 Capital Requirements

For the advanced internal ratings-based approach, the Basel III-based 

final rule eliminates the credit ratings-based approach that had been the 

primary method for determining risk weights for securitization exposures 

under the previous rules. The credit ratings-based approach assigned risk 

weights to securitization exposures based on their seniority in the 

securitization structure and the effective number of exposures (as 

determined by a formula), as well as their external ratings from one or 

more NRSROs or inferred ratings.27 These risk weights ranged from 7–20 

percent for the highest investment grade (long-term) securitization 

exposures (e.g., AAA) to 35–100 percent for the lowest investment grade 

exposures (e.g., BBB+, BBB, BBB-) to 250–650 percent for exposures 

one category below investment grade (e.g., BB+, BB, BB-).28

The primary method for banks using the advanced internal ratings-based 

approach to calculate capital requirements for securitization exposures is 

the supervisory formula approach. The supervisory formula approach was 

an alternative method banks could use under the Basel II-based rules for 

securitization exposures for which there was no applicable external or 

inferred credit rating. It has remained largely unchanged from the Basel IIbased rules with one significant exception: a 20 percent risk-weight floor, 

rather than a 7 percent risk-weight floor, now applies to all securitization 

exposures. The supervisory formula approach requires banks to calculate 

several input parameters on an ongoing basis. These include

 27If a securitization exposure does not have an external rating and another securitization 

exposure issued by the same issuer and secured by the same underlying exposures (1) 

has an external rating, (2) is subordinated in all respects to the unrated securitization 

exposure, (3) does not benefit from any credit enhancement that is not available to the 

unrated securitization exposure, and (4) has an effective remaining maturity that is equal 

to or longer than that of the unrated securitization exposure, the unrated securitization 

exposure has an inferred rating equal to the rated exposure’s external rating.

28Exposures rated more than one category below investment grade were to be deducted 

from tier 1 and tier 2 capital. (Tier 1 capital consists primarily of equity capital and retained 

earnings (the profits a bank has earned but has not paid out to shareholders in the form of 

dividends); tier 2 capital includes subordinated debt, a portion of loan loss allowances, and 

certain other instruments.) Separate risk weights were included for short-term credit 

weightings. These risk weights varied based on the exposures’ seniority in the 

securitization structure and the effective number of exposures (as determined by a 

formula) and ranged from 7 percent to 75 percent for the three highest investment grades. 

Securitization Calculations 

under the Advanced Internal 

Ratings-Based Approach
Page 17 GAO-17-93 Capital Requirements

• the exposure’s credit enhancement level and thickness;29

• the exposure-weighted average loss given default for the underlying 

exposures to the securitization transaction and the effective number of 

underlying exposures (both determined by formulas specified in the 

final rule); and

• the capital requirements for the underlying exposures, such as those 

for residential mortgage exposures described earlier.

If banks using the advanced internal ratings-based approach are unable 

to calculate the inputs for the supervisory formula approach, they may 

use the simplified supervisory formula approach described earlier.

The Basel III-based final rule changes the treatment of mortgage 

servicing assets by (1) lowering the cap on the amount of mortgage 

servicing assets that can be included in capital calculations, which 

reflects, in part, the uncertainty regarding the ability of banking institutions 

to realize value from these assets, especially under adverse financial 

conditions, and (2) increasing the risk weights. Mortgage servicing assets 

are the contractual rights owned by a banking organization to service (for 

a fee) mortgage loans that are owned by others. Under previous rules, 

banks included up to 90 percent of fair value or 100 percent of book value 

of mortgage servicing assets in their capital calculations, whichever was 

lower, and mortgage servicing assets were subject to 100 percent risk 

weight. In contrast, the final rule caps the recognition of mortgage 

servicing assets at 10 percent of the common equity component of tier 1 

capital.30 Mortgage servicing assets exceeding the 10 percent threshold 

must be deducted from common equity. Deductions from common equity 

reduce the numerator in banks’ calculations of their risk-based capital 

ratios. Mortgage servicing asset amounts that are not deducted from 

common equity are currently subject to a 100 percent risk weight, and 

that risk weight will increase to 250 percent beginning January 1, 2018, 

 29The credit enhancement level is the ratio of the amount of all securitization exposures 

subordinated to the tranche that contains the banking organization’s securitization 

exposure and the amount of the underlying exposures. The tranche thickness is measured 

by subtracting the attachment point from the detachment point and represents the 

maximum loss that can be sustained if the entire tranche were held.

30Common equity includes in part common shares that meet specified criteria and 

retained earnings. 

Risk Weights for Mortgage 

Servicing Assets Will 

Increase
Page 18 GAO-17-93 Capital Requirements

when the phase-in period ends.31 The future increase in the risk weight 

will increase risk-weighted assets, the denominator for banks’ risk-based 

capital ratios. As a result, both the stricter cap and higher risk weight on 

mortgage servicing assets will reduce banks’ risk-based capital ratios, 

making the required minimum level more difficult to maintain.

The final rule does not apply to the enterprises or nonbank financial 

institutions. The enterprises’ previous regulator, the Office of Federal 

Housing Enterprise Oversight, established risk-based capital 

requirements that were defined by stress test scenarios rather than fixed 

risk weights. A simulated stress test was used to project the enterprises’

financial performance over a 10 year period and measure capital 

adequacy, or the amount of capital required to survive a prolonged period 

of economic stress without new business or active risk management 

action. When the enterprises were placed in conservatorship in 2008, 

their new regulator, the Federal Housing Finance Agency, suspended the 

enterprises’ capital requirements.

Nonbank financial institutions such as nonbank mortgage servicers follow 

capital requirements established by Ginnie Mae and the enterprises in 

order to service loans these entities guaranteed, but these requirements 

do not involve risk weights. The minimum capital requirements that are 

currently in place or that have been proposed are shown in table 3.

Table 3: Nonbank Mortgage Servicer Capital and Liquidity Requirements

Fannie Mae/Freddie Mac Seller 

servicers

Ginnie Mae issuers Conference of State Bank 

Supervisors’ proposal

Minimum net worth

(dollars)

2.5 million plus 25 bps of servicing 

UPB

2.5 million plus 35 bps of servicing 

UPB

2.5 million plus 25 bps of servicing 

UPB

Minimum capital ratio

(percent)

Net worth/total assets>=6 Net worth/total assets>=6 None

 31In addition, the combined balance of mortgage servicing assets, deferred tax assets, 

and investments in the common stock of unconsolidated financial institutions is limited to 

15 percent of a bank’s common equity tier 1 capital. These combined assets must be 

deducted from common equity to the extent that they exceed the 15 percent threshold.

The Enterprises and 

Nonbank Financial 

Institutions Are Not 

Subject to the Final Rule 

or Capital Requirements 

That Involve Risk Weights
Page 19 GAO-17-93 Capital Requirements

Fannie Mae/Freddie Mac Seller 

servicers

Ginnie Mae issuers Conference of State Bank 

Supervisors’ proposal

Minimum liquidity ratio 3.5 bps of agency servicing UPB 

plus incremental 200 bps of NPL 

servicing over 6 percent agency 

UPB

Greater of 1 million dollars or 10 

bps of MBS outstanding

3.5 bps of all servicing UPB; no 

incremental charge

Effective date December 31, 2015 January 1, 2015 (new issuers);

December 31, 2015 (prior issuers)

Proposed

Legend: 

bps = basis points

UPB = unpaid principal balance

MBS = mortgage-backed securities

NPL = nonperforming loans

Source: The Urban Institute. | GAO-17-93

Note: The Conference of State Bank Supervisors’ proposal also includes enhanced prudential 

standards for large, complex nonbank mortgage servicing companies. The proposed enhanced 

prudential standards expand upon the baseline standards, and would be applied based on factors 

such as the number or dollar amount of loans serviced, the composition of the servicing portfolio, and 

the entity’s primary business (e.g., subservicing, master servicer). The state regulators noted a need 

for these larger entities to have in place advanced risk management and management information 

systems to mitigate risk. The proposal recommends that the more complex entities deploy enhanced 

planning, modeling, metrics, and audit in four areas: (1) capital, (2) liquidity, (3) stress testing, and (4) 

living will and recovery resolution plans.

The full impact of the changes to capital requirements for holdings of 

mortgage-related assets remains uncertain because insufficient time has 

passed since these changes took effect for both banks and nonbank 

mortgage servicers, and for some assets the changes have not yet been 

fully phased in. However, our past work suggested that—based on 

analysis of data included in banks’ Consolidated Reports of Condition and 

Income (commonly referred to as Call Reports) and Credit Union 5300 

Call Reports—many lenders generally appeared to be participating in 

residential mortgage lending much as they had in the past.32 In addition, 

data on mortgage debt outstanding published by the Federal Reserve 

indicate that holdings of mortgage debt for one-to-four family properties 

have remained consistent with trends that predate the 2014–2015 

changes in risk weights (see fig. 1): (1) mortgage debt held or guaranteed 

by the enterprises holding steady, (2) mortgage debt held by depository 

institutions also holding steady, (3) mortgage debt held or guaranteed by 

 32GAO, Mortgage Servicing: Community Lenders Remain Active under New Rules, but 

CFPB Needs More Complete Plans for Reviewing Rules, GAO-16-448 (Washington, D.C.: 

June 23, 2016).

Effects of Changes to 

Capital Requirements on 

Holdings of MortgageRelated Assets Are 

Uncertain
Page 20 GAO-17-93 Capital Requirements

Ginnie Mae continuing to increase slightly, and (4) mortgage debt backing 

private-label securities continuing its steady decline.

Figure 1: Volume of Mortgage Debt Outstanding by Holder or Guarantor, 2011 through Second Quarter 2016

But increased risk weights for some mortgage-related assets, among 

other factors, can have potential implications for banks’ decisions about 

securitizing and servicing mortgages and investing in MBS. Securitizing 

mortgages creates exposures that may carry increased risk weights for 

banks. These exposures can include mortgage servicing assets, recourse 

obligations, and residual interests. 

• As discussed previously, the cap on the amount of mortgage servicing 

assets that can be included in capital calculations is now lower than it 

previously was—10 percent of common equity rather than either 90 

percent of fair value or 100 percent of book value. Banks that exceed 

the cap may need to hold more capital for these assets. In addition, 

mortgage servicing assets will have a higher risk weight under the 

final rule beginning in 2018, which will also increase the capital 

required for these assets. Fewer banks may want to retain these 

servicing rights and instead may seek to sell them to nonbank 

financial institutions that are not subject to the final rule. The total 

amount of mortgage servicing assets held by banks peaked in 2009 
Page 21 GAO-17-93 Capital Requirements

and generally has been decreasing in subsequent years, according to 

data compiled by SNL Financial. In 2016 reports on mortgage 

servicing and nonbank servicers, we found that the share of U.S. 

residential mortgages serviced by nonbank servicers increased from 

approximately 6.8 percent in the first quarter of 2012 to approximately 

24.2 percent in the second quarter of 2015, while the share serviced 

by the largest nationwide, regional, and other banks decreased from 

about 75.4 percent to about 58.6 percent over the same period.33

• Banking organizations may face recourse obligations (for example, to 

repurchase mortgages they have sold to others) when loans default 

within a certain period after the sale. Banks reported a decreasing 

amount of residential mortgages serviced for others with recourse, 

according to data compiled by SNL Financial, but this trend predates 

the Basel III-based final rule. 

• Under current credit risk retention rules, banks must retain an interest 

equal to at least 5 percent of the credit risk for mortgage-backed 

securities they sponsor unless the security qualifies for an applicable 

exemption, including being exclusively backed by mortgages that 

meet the definition of a “qualified mortgage.”34 These residual 

interests are included in risk-weighted assets and may carry higher 

risk weights under the Basel III-based rules than under the previous 

rules, depending on how they are structured. Residual interests that 

are structured as a vertical slice of the securitization structure 

(meaning the sponsor retains a 5 percent interest in each tranche) 

would have a lower risk weight than residual interests that are 

structured as a horizontal slice of the securitization (meaning the 

sponsor retains the most junior 5 percent interest in the securitization 

structure). Few transactions involving the securitization of mortgages 

that do not meet the qualified mortgage definition have been 

completed since the rule went into effect. Instead, banks may be 

electing to hold these mortgages in their portfolios or to originate 

loans that meet the qualified mortgage definition, including those that 

 33GAO-16-448 and GAO, Nonbank Mortgage Servicers: Existing Regulatory Oversight 

Could Be Strengthened, GAO-16-278 (Washington, D.C.: Mar. 10, 2016). The remaining 

17.2 percent of mortgages are serviced by other bank servicers, such as community 

banks and credit unions. 

34For a more complete discussion of these regulations and other recent mortgage 

reforms, see GAO, Mortgage Reforms: Actions Needed to Assess Effects of New 

Regulations, GAO-15-185 (Washington D.C.: June 25, 2015).
Page 22 GAO-17-93 Capital Requirements

can be sold to the enterprises. The increase in banks’ holdings of 

securities backed by the enterprises could be evidence of this latter 

scenario, as banks often deliver loans to the enterprises in exchange 

for enterprise MBS. Holdings of enterprise MBS would have lower risk 

weights than holding whole loans in portfolio (whether or not they 

meet the qualified mortgage definition).

Finally, the Basel III-based final rule largely left unchanged the historically 

lower risk weights of MBS guaranteed by the enterprises vis-à-vis other 

mortgage-related assets, which can influence the demand for these 

securities relative to whole loans and privately issued MBS. While 

holdings of MBS guaranteed by Ginnie Mae retain a 0 percent risk weight 

and holdings of MBS guaranteed by the enterprises retain a 20 percent 

risk weight under the standardized approach (and their treatment under 

the advanced approach has not changed), holdings of privately issued 

MBS may face higher risk weights than under the prior rules. For privately 

issued MBS that have an external credit rating, the minimum weight 

increased from 7 percent to 20 percent for banks subject to the advanced 

approach, and the junior tranches of these MBS are likely subject to 

higher risk weights in part because credit ratings can no longer be used to 

calculate risk weights. According to data compiled by SNL Financial, 

banks’ holdings of MBS guaranteed by Ginnie Mae and the enterprises 

have been increasing while their holdings of other residential MBS have 

been decreasing, but these trends predate the changes to risk weights for 

privately issued MBS.

We sought and received technical comments on a draft of this report from 

the Board of Governors of the Federal Reserve System, Office of the 

Comptroller of the Currency, and Federal Deposit Insurance Corporation 

and incorporated their comments and feedback into the final report.

We are sending copies of this report to the appropriate congressional 

committees and other interested parties. In addition, the report is 

available at no charge on the GAO website at http://www.gao.gov.

Agency Comments
Page 23 GAO-17-93 Capital Requirements

If you or your staff have any questions about this report, please contact 

me at (202) 512-8678 or evansl@gao.gov. Contact points for our Offices 

of Congressional Relations and Public Affairs may be found on the last 

page of this report. GAO staff who made major contributions to this report 

are listed in appendix III.

Sincerely yours,

Lawrance L. Evans, Jr.

Director, Financial Markets and

 Community Investment
Appendix I: Calculation of Risk-Weighted 

Assets for Retail Exposures under the 

Advanced Internal Ratings-Based Approach

Page 24 GAO-17-93 Capital Requirements

Under the advanced internal ratings-based approach, residential 

mortgages are included in retail exposures. Generally, a banking 

organization must calculate retail risk-weighted asset amounts in four 

distinct phases:

1. Phase 1 – Categorization of exposures

During this phase, the banking organization determines which of its 

exposures are wholesale exposures, retail exposures, securitization 

exposures, or equity exposures.1 Retail exposures are further categorized 

as residential mortgage exposures, qualifying revolving exposures, or 

other retail exposures.2

2. Phase 2 – Segmentation of retail exposures

During the second phase, a banking organization must group the retail 

exposures in each retail subcategory into segments that have 

homogeneous risk characteristics. A banking organization must also 

segment defaulted retail exposures separately from nondefaulted retail 

exposures.

3. Phase 3 – Assignment of risk parameters to segments of retail 

exposures

 1

Wholesale exposures include most credit exposures to companies, sovereigns, and other 

governmental entities. Retail exposures include most credit exposures to individuals and 

small credit exposures to businesses that are managed as part of a segment of exposures 

with similar risk characteristics and not managed on an individual-exposure basis. 

2

A residential mortgage exposure is an exposure that is primarily secured by a first or 

subsequent lien on a one-to-four family residential property or an exposure with an original 

and outstanding amount of $1 million or less that is primarily secured by a first or 

subsequent lien on residential property that is not one-to-four family that is managed as 

part of a segment of exposures with homogeneous risk characteristics and not on an 

individual-exposure basis. Qualifying revolving exposures are exposures to individuals 

that are revolving, unsecured, and unconditionally cancelable by the bank; have a 

maximum exposure amount (drawn plus undrawn) of up to $100,000, or with respect to a 

product with an outstanding amount that the borrower is required to pay in full every 

month, the total outstanding amount does not in practice exceed $ 100,000; and are 

managed as part of a segment of exposures with homogeneous risk characteristics. 

These would include most credit card exposures to individuals and overdraft lines on 

individual checking accounts.

Appendix I: Calculation of Risk-Weighted 

Assets for Retail Exposures under the 

Advanced Internal Ratings-Based Approach
Appendix I: Calculation of Risk-Weighted 

Assets for Retail Exposures under the 

Advanced Internal Ratings-Based Approach

Page 25 GAO-17-93 Capital Requirements

During phase 3, the banking organization must associate a probability of 

default (PD), a loss given default (LGD), and an exposure at default 

(EAD) to each segment of retail exposures such as residential mortgages.

The PD for each retail segment may not be less than 0.03 percent, except 

for exposures to or directly guaranteed by a sovereign entity. Also, the 

LGD for each segment of residential mortgage exposures may not be less 

than 10 percent, with two exceptions. One exception is for segments of

residential mortgage exposures for which all or substantially all of the 

principal of each exposure is guaranteed by the full faith and credit of a 

sovereign or other qualified entity. The other exception is for segments of 

residential mortgage exposures for which all or substantially all of the 

principal of each exposure is guaranteed by a contingent obligation of the 

U.S. government or its agencies, the enforceability of which is dependent 

upon some affirmative action on the part of the beneficiary of the 

guarantee or a third party (for example, meeting servicing requirements). 

Banking organizations may take into account the risk-reducing effects of 

eligible guarantees and credit derivatives in support of retail exposures in 

a segment when quantifying the PD and LGD of the segment. Similarly, 

banking organizations may also take into account the risk-reducing 

effects of collateral in support of retail exposures when quantifying PD 

and LGD of the segment, provided the banking organization has 

established operational procedures and risk-management processes that 

ensure that all documentation used in collateralizing or guaranteeing a 

transaction is legal, valid, binding, and enforceable.

4. Phase 4 – Calculation of risk-weighted assets

A banking organization must calculate the dollar risk-based capital 

requirement for segments of nondefaulted retail exposures by inserting 

the assigned risk parameters for the retail segment into the appropriate 

risk-based capital formula specified in the following formula, and multiply 

the output of the formula (K) by the EAD of the segment:

KK = LLLLLL × NN �

NN−1(PP ) + √R × NN−1(0.999)

√1 − R � − (LLLLLL × PP )

where K represents the capital charge; N(.) means the cumulative 

distribution function for a standard normal random variable; N-1(.) means 

the inverse cumulative distribution function for a standard normal random 

variable; and R is the non-defaulted exposures correlation factor. For 

residential mortgage exposures, R is set equal to 0.15 in the Basel IIIbased final rule.
Appendix I: Calculation of Risk-Weighted 

Assets for Retail Exposures under the 

Advanced Internal Ratings-Based Approach

Page 26 GAO-17-93 Capital Requirements

Assuming LGD equals 20 percent and PD equals 3 percent, the capital 

calculation would be as follows for a non-defaulted residential mortgage 

exposure:

KK = 0.2 × NN �

NN−1(0.03) + √0.15 × NN−1(0.999)

√0.85 � − (0.2 × 0.03)

NN−1(0.03) = −1.88079

NN−1(0.999) = 3.09023

KK = 0.2 × NN �

−1.88079 + 0.3873 × 3.09023

0.92195 � − (0.006)

KK = 0.2 × NN(−0.74185) − (0.006)

NN(−0.74185) = 0.22909

KK = 0.2 × 0.22909 − (0.006)

KK = .03982, or approximately 4%

The capital charge, K, reflects the risk weight multiplied by the minimum 

capital requirement. Therefore, dividing the capital charge of 

approximately 4 percent by the minimum capital requirement of 8 percent 

produces a risk weight of about 50 percent.
Appendix II: Specification of the Simplified 

Supervisory Formula Approach

Page 27 GAO-17-93 Capital Requirements

The Basel III-based final rule promulgated by the U.S. federal banking 

regulators specifies the following calculations and parameters for 

determining risk weights using the simplified supervisory formula 

approach:

KKGG = the weighted average capital charge for exposures underlying the 

securitization

WW = the proportion of the underlying exposures that are delinquent

AA = attachment point, the threshold at which credit losses will first be 

allocated to the exposure

= detachment point, the threshold at which credit losses allocated to 

the exposure would result in a total loss of principal

The starting point is calculating KKGG for the exposures underlying the 

securitization exposure. For example, if the underlying exposures are 

residential mortgages that are not guaranteed by a U.S. government 

agency, they would have risk weights of 50 percent or 100 percent 

(depending on whether they meet certain criteria), which is multiplied by 

the minimum capital requirement of 8 percent. Assuming 90 percent of 

the mortgages have a 50 percent risk weight and 10 percent have a 100 

percent risk weight because they are delinquent, KKGG would equal 0.9 × 0.5 

× 0.08 plus 0.1× 1.0 × 0.08, or 0.044.

Next, the following formula is used to calculate KKAA, which is the 

augmented capital charge that reflects the observed credit quality of the 

underlying exposures:

KKAA = (1 − WW) × KKGG + (0.5 × WW)

To continue the example, substituting 0.1 for W (for the 10 percent of 

mortgages that are delinquent) and 0.044 for KKGG, results in a value for KKAA

of 0.0896.

The next step is to compare KKAA with parameters D and A. If parameter D 

for a securitization exposure is less than or equal to KKAA (in other words, if 

the tranche is junior to KKAA), the exposure must be assigned a risk weight 

of 1,250 percent (i.e., bank must hold “dollar for dollar” capital against that 

tranche). If D is 0.07, which is less than the value of KKAA in the example 

just discussed, then the risk weight on the exposure is 1,250 percent.

Appendix II: Specification of the Simplified 

Supervisory Formula Approach
Appendix II: Specification of the Simplified 

Supervisory Formula Approach

Page 28 GAO-17-93 Capital Requirements

However, if parameter A for a securitization exposure is greater than or 

equal to KKAA (in other words, if the tranche is senior to KKAA), the risk weight 

of the exposure, expressed as a percent, would equal the greater of KKSSSSSS

× 1,250 percent and the supervisory floor of 20 percent. So if A is 0.10 

(which is greater than 0.0896, the value of KKAA in this example), then KKSSSSSS

needs to be calculated. KKSSSSSS is the capital charge for the securitization 

exposure using the simplified supervisory formula approach. The 

following formulas and parameters are specified in the final rule:

KKSSSSSS = eaaaa − eaaaa

aa(uu − ll)

ee = 2.71828

aa = −1

pp × KKAA

uu = − KKAA

ll = max(AA − KKAA, 0)

pp = 1.5 for resecuritizations and 0.5 otherwise

In this example, the exposure does not contain any resecuritizations, so pp

(a supervisory calibration parameter) is 0.5. Assume A equals 0.10 and D 

equals 0.15 for this securitization exposure. Then:

aa = −1

0.5 × 0.0896 = −22.3214

uu = 0.15 − 0.0896 = 0.0604

ll = max(0.10 − 0.0896, 0) = .0104

And:

KKSSSSSS = 2.71828(−22.3214×0.0604) − 2.71828(−22.3214×0.0104)

−22.3214(0.0604 − 0.0104) = 0.4777

Multiplying KKSSSSSSAA by 1,250 percent results in a risk weight of 

approximately 597 percent.
Appendix II: Specification of the Simplified 

Supervisory Formula Approach

Page 29 GAO-17-93 Capital Requirements

But if parameter A is less than KKAA and D is greater than KKAA (in other 

words, if the tranche straddles KKAA), the applicable risk weight (RW) is the 

greater of the 20 percent supervisory floor and the weighted average of 

1,250 percent and 1,250 percent × KKSSSSSS as determined according to the 

following:

RR = ��

KKAA − AA

− AA � × 1,250%� + �� − KKAA

− AA � × 1,250% × KKSSSSSS �

For the example discussed in this appendix, this would be the case if A

equals 0.08 and D equals 0.12, with KKAA still equal to 0.0896. Then:

aa = −1

0.5 × 0.0896 = −22.3214

uu = 0.12 − 0.0896 = 0.0304

ll = max(0.08 − 0.0896, 0) = 0

And:

KKSSSSSS = 2.71828(−22.3214×0.0304) − 2.71828(−22.3214×0)

−22.3214(0.0304 − 0) = 0.726

Then, applying the formula for RW above results in a risk weight of about 

989 percent:

RR = ��

0.0896 − 0.08

0.12 − 0.08 � × 1,250%� + ��

0.12 − 0.0896

0.12 − 0.08 � × 1,250% × 0.726�

= 9.8919 or 989%
Appendix III: GAO Contact and Staff 

Acknowledgments

Page 30 GAO-17-93 Capital Requirements

Lawrance L. Evans, Jr., (202) 512-8678 or evansl@gao.gov

In addition to the contact named above, Karen Tremba (Assistant 

Director), Don Brown (Analyst-in-Charge), M’Baye Diagne, Rachel 

DeMarcus, Marc Molino, Jennifer Schwartz, and Tyler Spunaugle made 

significant contributions to this report.

Appendix III: GAO Contact and Staff 

Acknowledgments

GAO Contact

Staff 

Acknowledgments

(101130)
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