59944 Federal Register / Vol. 62, No. 214 / Wednesday, November 5, 1997 / Proposed Rules

DEPARTMENT OF THE TREASURY

Office of the Comptroller of the

Currency

12 CFR Part 3

[Docket No. 97–22]

RIN 1557–AB14

FEDERAL RESERVE SYSTEM

12 CFR Parts 208 and 225

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

FEDERAL DEPOSIT INSURANCE

CORPORATION

12 CFR Part 325

RIN 3064–AB31

DEPARTMENT OF THE TREASURY

Office of Thrift Supervision

12 CFR Part 567

[Docket No. 97–86]

RIN 1550–AB11

Risk-Based Capital Standards;

Recourse and Direct Credit Substitutes

AGENCIES: Office of the Comptroller of

the Currency, Treasury; Board of

Governors of the Federal Reserve

System; Federal Deposit Insurance

Corporation; and Office of Thrift

Supervision, Treasury.

ACTION: Joint notice of proposed

rulemaking.

SUMMARY: The Office of the Comptroller

of the Currency (OCC), Board of

Governors of the Federal Reserve

System (Board), Federal Deposit

Insurance Corporation (FDIC), and

Office of Thrift Supervision (OTS),

(collectively, the agencies) are

proposing revisions to their risk-based

capital standards to address the

regulatory capital treatment of recourse

obligations and direct credit substitutes

that expose banks, bank holding

companies, and thrifts (collectively,

banking organizations) to credit risk.

The proposal would treat direct credit

substitutes and recourse obligations

consistently and would use credit

ratings and possibly certain other

alternative approaches to match the

risk-based capital assessment more

closely to a banking organization’s

relative risk of loss in asset

securitizations.

The agencies intend that any final

rules adopted in connection with this

proposal that result in increased riskbased 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

regs.comments@occ.treas.gov or by mail

to Docket No. 97–22, Communications

Division, Third Floor, Office of the

Comptroller of the Currency, 250 E

Street, SW., Washington, DC 20219.

Comments will be available for

inspection and photocopying at that

address.

Board: Comments, which should refer

to Docket No. R–0985, may be mailed to

the Board of Governors of the Federal

Reserve System, 20th Street and

Constitution Avenue, NW., Washington,

DC 20551, to the attention of Mr.

William Wiles, Secretary. Comments

addressed to the attention of Mr. Wiles

may be delivered to the Board’s mail

room between 8:45 a.m. and 5:15 p.m.,

and to the security control room outside

of those hours. Both the mail room and

the security control room are accessible

from the courtyard entrance on 20th

Street between Constitution Avenue and

C Street, NW. Comments may be

inspected in Room MP500 between 9

a.m. and 5 p.m. weekdays, except as

provided in § 261.8 of the FRB’s Rules

Regarding Availability of Information,

12 CFR 261.8.

FDIC: Written comments should be

addressed to Robert E. Feldman,

Executive Secretary, Attention:

Comments/OES, Federal Deposit

Insurance Corporation, 550 17th Street,

N.W., Washington, D.C. 20429.

Comments may be hand delivered to the

guard station at the rear of the 550 17th

Street Building (located on F Street), on

business days between 7:00 a.m. and

5:00 p.m. (Fax number: (202) 898–3838;

Internet address: comments@fdic.gov).

Comments may be inspected and

photocopied in the FDIC Public

Information Center, Room 100, 801 17th

Street, N.W., Washington, D.C., between

9:00 a.m. and 4:30 p.m. on business

days.

OTS: Send comments to Manager,

Dissemination Branch, Records

Management and Information Policy,

Office of Thrift Supervision, 1700 G

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

Attention Docket No. 97–86. These

submissions may be hand-delivered to

1700 G Street, N.W., from 9:00 a.m. to

5:00 p.m. on business days or may be

sent by facsimile transmission to FAX

number (202) 906–7755; or by e-mail:

public.info@ots.treas.gov. Those

commenting by e-mail should include

their name and telephone number.

Comments will be available for

inspection at 1700 G Street, N.W., from

9:00 to 4:00 p.m. on business days.

FOR FURTHER INFORMATION CONTACT:

OCC: David Thede, Senior Attorney,

Securities and Corporate Practices

Division (202/874–5210); Dennis

Glennon, Financial Economist, Risk

Analysis Division (202/874–5700); 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
Federal Register / Vol. 62, No. 214 / Wednesday, November 5, 1997 / Proposed Rules 59945

1The OTS is adding a definition of ‘‘standby-type

letter of credit’’ to be consistent with the other

agencies.

2See 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).

4As used in this proposal, the terms ‘‘credit

enhancement’’ and ‘‘enhancement’’ refer to both

recourse arrangements and direct credit substitutes.

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

• 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.

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 riskbased 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 Federallysponsored 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 Federallysponsored agency. Sellers of these

privately securitized assets therefore

often provide other forms of credit

enhancement—first and second dollar

loss positions—to reduce investors’ risk

of credit loss.

Sellers may provide this credit

enhancement themselves through

recourse arrangements. For purposes of

this proposal, ‘‘recourse’’ refers to any

risk of credit loss that an institution

retains in connection with the transfer

of its assets. While banking

organizations have long provided

recourse in connection with sales of

whole loans or loan participations,

recourse arrangements today are

frequently associated with asset

securitization programs.

Sellers may also arrange for a third

party to provide credit enhancement in

an asset securitization. If the third-party

enhancement is provided by another

banking organization, that organization

assumes some portion of the assets’

credit risk. For purposes of this

proposal, all forms of third-party

enhancements, i.e., all arrangements in

which an institution assumes risk of

credit loss from third-party assets or

other claims that it has not transferred,

are referred to as ‘‘direct credit

substitutes.’’ 4 The economic substance

of an institution’s risk of credit loss

from providing a direct credit substitute

can be identical to its risk of credit loss

from transferring an asset with recourse.

Depending on the type of

securitization transaction, a portion of

the total credit enhancement may also

be provided internally, as part of the

securitization structure, through the use

of spread accounts, overcollateralization, or other forms of selfenhancement. Many asset

securitizations use a combination of

internal enhancement, recourse, and

third-party enhancement to protect

investors from risk of credit loss.

2. Prior History

On June 29, 1990, the Federal

Financial Institutions Examination

Council (FFIEC) published a request for

comment on recourse arrangements. See
59946 Federal Register / Vol. 62, No. 214 / Wednesday, November 5, 1997 / Proposed Rules

5Current rules also provide for special treatment

of sales of small business loan obligations with

recourse. See 12 U.S.C. 1835.

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 onbalance sheet credit equivalent amount

using a 100% credit conversion factor,

and this credit equivalent amount is

risk-weighted. 5 In either case, riskbased capital is held against the full,

risk-weighted amount of the transferred

assets, subject to the low-level recourse

rule which limits the maximum riskbased capital requirement to the bank’s

maximum contractual obligation.

For leverage capital ratio purposes, if

a sale with recourse is reported as a

financing, then the assets sold with

recourse remain on the selling bank’s

balance sheet. If a sale with recourse is

reported as a sale, the assets sold do not

remain on the selling bank’s balance

sheet.

2. Direct Credit Substitutes

a. Banking Agencies. Direct credit

substitutes are treated differently from

recourse under the current risk-based

capital standards. Under the Banking

Agencies’ standards, off-balance sheet

direct credit substitutes, such as

financial standby letters of credit

provided for third-party assets, carry a

100% credit conversion factor.

However, only the dollar amount of the

direct credit substitute is converted into

an on-balance sheet credit equivalent so

that capital is held only against the face

amount of the direct credit substitute.

The capital requirement for a recourse

arrangement, in contrast, is generally

based on the full amount of the assets

enhanced.

If a direct credit substitute covers less

than 100% of the potential losses on the

assets enhanced, the current capital

treatment results in a lower capital

charge for a direct credit substitute than

for a comparable recourse arrangement.

For example, if a direct credit substitute

covers losses up to the first 20% of the

assets enhanced, then the 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
Federal Register / Vol. 62, No. 214 / Wednesday, November 5, 1997 / Proposed Rules 59947

6The OTS has followed GAAP since 1989 for

reporting purposes and for computation of the

capital leverage ratio.

7The OTS currently defines the term ‘‘recourse’’

more broadly than the proposal to include

arrangements involving credit risk that a thrift

Continued

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.

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
59948 Federal Register / Vol. 62, No. 214 / Wednesday, November 5, 1997 / Proposed Rules

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.’’

8Current 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.

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 riskbased 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 noncredit 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

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
Federal Register / Vol. 62, No. 214 / Wednesday, November 5, 1997 / Proposed Rules 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 openended 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.
59950 Federal Register / Vol. 62, No. 214 / Wednesday, November 5, 1997 / Proposed Rules

9Servicer 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).

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.

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 multilevel approach could be implemented.

Some commenters suggested that the

agencies adopt a comprehensive

approach, implementing a change in the

treatment of direct credit substitutes

only in the context of a multi-level

approach, and observed that a

piecemeal approach would be unduly

disruptive. The agencies agree and now

propose to implement the change in the

treatment of direct credit substitutes in

combination with the multi-level

approach. As proposed, the multi-level

approach applies to direct credit

substitutes and recourse obligations

related to asset securitizations. The

agencies request comment on how the

final rule could prudently and

effectively apply the multi-level

approach to direct credit substitutes and

recourse obligations not related to asset

securitizations.

Several commenters objected to the

proposed treatment of direct credit

substitutes as recourse. Commenters

objected that the proposed capital

treatment would impair the competitive

position of U.S. banks and thrifts and

that the business of providing thirdparty credit enhancements has

historically been safe and profitable for

banks. Notwithstanding these concerns,

the agencies believe that the current

treatment of direct credit substitutes is

not consistent with the treatment of

recourse obligations, and that the

difference in treatment between the two

forms of credit enhancement invites

institutions to convert recourse

obligations into direct credit substitutes

in order to avoid the capital requirement

applicable to recourse obligations and

balance-sheet assets. The agencies

request comment on the proposed

treatment of direct credit substitutes and

on the effect of the proposed treatment

on the competitive position of U.S.

banks.

The Banking Agencies have raised the

issue of increasing the capital

requirement for direct credit substitutes

and lowering the capital requirement for

highly-rated senior securities with the

bank supervisory authorities from the

other countries represented on a

subgroup of the Basle Committee on

Banking Supervision in an effort to

eliminate competitive inequities.

C. Multi-level Ratings-based Approach

Many asset securitizations carve up

the risk of credit losses from the

underlying assets and distribute it to

different parties. A credit enhancement

(that is, a recourse arrangement or direct

credit substitute) that has no prior loss

protection is a ‘‘first dollar’’ loss

position. There may be one or more

layers of additional credit enhancement

after the first dollar loss position. Each

loss position functions as a credit

enhancement for the more senior loss
Federal Register / Vol. 62, No. 214 / Wednesday, November 5, 1997 / Proposed Rules 59951

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.

11Under 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.

12See T. McGuire, Moody’s Investors Service,

Ratings in Regulation: A Petition to the Gorillas

(1995).

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

• A position rated in the highest

investment grade rating category would

receive a 20 percent risk weight.

• A position rated investment grade

but not in the highest rating category

would receive one of two alternative

treatments the agencies are considering:

(1) The ‘‘face value’’ option would apply

a 100 percent risk weight to the book

value or face amount of the position; or

(2) the ‘‘modified gross-up’’ option

would apply a 50 percent risk weight to

the amount of the position plus all more

senior positions. (Section II.D of this

preamble discusses and provides

examples of these two alternatives.)

• Recourse obligations and direct

credit substitutes not qualifying for a

reduced capital charge and positions

rated below investment grade would

receive ‘‘gross-up’’ treatment—the

institution holding the position would

hold capital against the amount of the

position plus all more senior positions,

subject to the low-level recourse rule.11

If a recourse obligation, direct credit

substitute, or senior security receives

different ratings from the rating

agencies, the highest ratings would

determine the capital 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 ratingsbased approach was not a perfect or

complete solution, especially for nontraded positions that would otherwise

not need to be rated. The agencies

recognize additional options for nontraded 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, multilevel 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 ratingsbased 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.

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-
59952 Federal Register / Vol. 62, No. 214 / Wednesday, November 5, 1997 / Proposed Rules

13The 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.

15The 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.

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 grossup’’ approach, would gross-up all

investment grade positions below the

highest investment grade level and then

apply a 50 percent risk weight to the

grossed-up amount. For senior

investment grade positions below the

highest investment grade level, this

approach would have the effect of

applying a 50 percent risk weight to

these positions.14 The agencies seek

comment on which of these two

alternative approaches should be

adopted or on possible alternatives to

the two described here.

a. Rationale for the Modified GrossUp 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

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
Federal Register / Vol. 62, No. 214 / Wednesday, November 5, 1997 / Proposed Rules 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 ratingsbased approach.

(Question 7). For the modified grossup 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
59954 Federal Register / Vol. 62, No. 214 / Wednesday, November 5, 1997 / Proposed Rules

BILLING CODE 4810–33–C
Federal Register / Vol. 62, No. 214 / Wednesday, November 5, 1997 / Proposed Rules 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 grossup 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 grossup 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 grossup approaches, Bank A, retaining the bottomlevel 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 grossedup 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]

Position Size

($ mil)

Credit

rating

Current capital

requirement

for thrifts

($ mil)

Current capital

requirement

for banks

($ mil)

Face value

approach

($ mil)

Modified

gross-up approach

($ 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 (firstloss) 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]

Position Size

($ mil)

Credit

rating

Current capital

requirement

for thrifts

($ mil)

Current capital

requirement

for banks

($ mil)

Face value

approach

($ mil)

Modified

gross-up approach

($ 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
59956 Federal Register / Vol. 62, No. 214 / Wednesday, November 5, 1997 / Proposed Rules

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 (lowlevel 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 grossup 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]

Position Size

($ mil)

Credit

rating

Current capital

requirement

for thrifts

($ mil)

Current capital

requirement

for banks

($ mil)

Face value

approach

($ mil)

Modified

gross-up approach

($ 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]

Position Size

($ mil)

Credit

rating

Current capital

requirement

for thrifts

($ mil)

Current capital

requirement

for banks

($ mil)

Face value

approach

($ mil)

Modifiedgross-up approach

($ 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
Federal Register / Vol. 62, No. 214 / Wednesday, November 5, 1997 / Proposed Rules 59957

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.

17A 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.

18A 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.

19See 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.

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

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 multilevel ratings based approach.

Consistent with comments received

on the 1994 Notice and the types of

credit enhancement generally relied on

by the ratings agencies in rating asset

pools, the agencies would also permit

forms of prior credit enhancement

involving third-party performance risk.

Specifically, the agencies would permit:

pool insurance, financial guarantees,

and standby letters of credit issued or

guaranteed by companies rated or

whose debt is rated, in the highest two

investment categories by two rating

agencies or similar rating organizations.

Third party credit enhancements would

qualify under the ratings benchmark

approach if: (1) the credit enhancement

absorbs credit losses before an

institution’s non-traded position absorbs

losses; and (2) the credit enhancement

represents an unconditional obligation

of the third party providing the

enhancement.

c. Computation of Capital

Requirements under the Ratings

Benchmark Approach. Non-traded

positions in asset securitizations

meeting the benchmark standards

would receive the same capital

treatment as investment grade positions

under the 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.

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.
59958 Federal Register / Vol. 62, No. 214 / Wednesday, November 5, 1997 / Proposed Rules

RESIDENTIAL MORTGAGE-BACKED SECURITIES

Pool Type 1, 2 ‘‘Rating Benchmark’’ prior credit 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), (2,6).

2.4 percent ................................................................................................................... No borrower concentration

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.

1For positions that represent less than 10 percent of the size of the underlying pool of loans, add 20 percent to the enhancement level.

2For 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. 3The reduction in the multiplier over time reflects the reduced risk of the mortgage portfolio due to seasoning.

4For 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

Pool Type 1 ‘‘Rating Benchmark’’ prior credit enhancement required for ‘‘A’’ rating Pool standards

Credit cards 2 ........................ The higher of 6 percent or 1.2 times lagged charge-off rate 3 .................................... Enhancement has access

to 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 expected loss rate 4 .................................. Enhancement has access

to excess spread.

Trade Receivables ............... 12.0 percent per loan pool 5 (if all sellers of trade receivables are rated 1 or 2) 18.0

percent per loan pool 5 (if any seller of trade receivables is rated 3 or 4 and no

lower than 4).

Pools may not have seller

concentrations above 5

percent of pool amount.

...................................................................................................................................... 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 as a percentage of outstanding principal, with a floor of 3 percent of original principal.For credit cards and auto

loans, pool must be randomly selected and nationally-diversified.

1For 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. 5Overcollateralization amount would count toward credit enhancement.

COMMERCIAL MORTGAGE-BACKED SECURITIES

Pool type 1 ‘‘Rating Benchmark’’ prior credit enhancement

required for ‘‘A’’ rating Pool standards

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

least 1.25
Federal Register / Vol. 62, No. 214 / Wednesday, November 5, 1997 / Proposed Rules 59959

20The reduction in the required credit

enhancement amount over time is due to the

reduced credit risk of seasoned mortgage loan

pools.

21 If the institution has experience with this type

of pool, then this historical experience should be

used to determine the loss rate required to

determine the benchmark.

COMMERCIAL MORTGAGE-BACKED SECURITIES—Continued

Pool type 1 ‘‘Rating Benchmark’’ prior credit enhancement

required for ‘‘A’’ rating Pool standards

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 loans with loan-to-value ratios less than

or equal to 70 percent. For pools of loans with greater than 70 percent loan-tovalue ratio, multiply the above enhancements by 1.5.

For each type of pool

above:

—No borrower concentration over 5 percent of

pool amount.

—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..

1For positions that represent less than 10 percent of the underlying pool of loans, add 20 percent to the credit enhancement level.

2For 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

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 grossup 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.

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 overcollateralization 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
59960 Federal Register / Vol. 62, No. 214 / Wednesday, November 5, 1997 / Proposed Rules

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 nontraded 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 lowlevel 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 riskbased 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
Federal Register / Vol. 62, No. 214 / Wednesday, November 5, 1997 / Proposed Rules 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 nontraded 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 riskweighted 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 nontraded 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
59962 Federal Register / Vol. 62, No. 214 / Wednesday, November 5, 1997 / Proposed Rules

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

* * * * *
Federal Register / Vol. 62, No. 214 / Wednesday, November 5, 1997 / Proposed Rules 59963

16Participations in performance-based standby

letters of credit are treated in accordance with

section 3(d) of this appendix A.

17Participations in commitments are treated in

accordance with section 3(d) of this appendix A.

Section 3. Risk Categories/Weights for OnBalance Sheet Assets and Off-Balance Sheet

Items

* * * * *

(b) * * * However, direct credit

substitutes, recourse obligations, and

securities issued in connection with asset

securitizations are treated as described in

section 3(d) of this appendix A.

(1) * * *

(ii) Risk participations purchased in

bankers’ acceptances.

* * * * *

(2) * * *

(i) * * * 16* * *

(ii) * * * 17* * *

* * * * *

(d) Recourse obligations, direct credit

substitutes, and asset- and mortgage-backed

securities. (1) Definitions. For purposes of

this section 3 of this appendix A:

(i) Direct credit substitute means an

arrangement in which a national bank

assumes, in form or in substance, any risk of

credit loss directly or indirectly associated

with a third-party asset or other financial

claim, that exceeds the national bank’s pro

rata share of the asset or claim. If a national

bank has no claim on the asset, then the

assumption of any risk of credit loss is a

direct credit substitute. Direct credit

substitutes include, but are not limited to:

(A) Financial guarantee-type standby

letters of credit that support financial claims

on the account party;

(B) Guarantees, surety arrangements, and

irrevocable guarantee-type instruments

backing financial claims;

(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 assetor mortgage-backed security that is retained,

assumed, or issued in connection with an

asset securitization and that was rated with

a reasonable expectation that, in the near

future:

(A) The position would be sold to investors

relying on the rating; or

(B) A third party would, in reliance on the

rating, enter into a transaction such as a

purchase, loan or repurchase agreement

involving the position.

(2) Risk-weighted asset amount. Except as

otherwise provided in sections 3(d)(3) and (4)

of this appendix A, to calculate the riskweighted 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
59964 Federal Register / Vol. 62, No. 214 / Wednesday, November 5, 1997 / Proposed Rules

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 riskweighted 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 onbalance 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
Federal Register / Vol. 62, No. 214 / Wednesday, November 5, 1997 / Proposed Rules 59965

23That is, a participation in which the originating

bank remains liable to the beneficiary for the full

amount of the direct credit substitute if the party

that has acquired the participation fails to pay when

the instrument is drawn.

24A risk participation in bankers acceptances

conveyed to other institutions is also assigned to

the risk category appropriate to the institution

acquiring the participation or, if relevant, the

guarantor or nature of the collateral.

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 assetor mortgage-backed security that is retained,

assumed, or issued in connection with an

asset securitization and that is rated with a

reasonable expectation that, in the near

future:

(i) The position would be sold to investors

relying on the rating; or

(ii) A third party would, in reliance on the

rating, enter into a transaction such as a

purchase, loan, or repurchase agreement

involving the position.

(b) Amount of position to be included in

risk-weighted assets—(1) Determining the

credit equivalent amount of recourse

obligations and direct credit substitutes. The

credit equivalent amount for a recourse

obligation or direct credit substitute (except

as otherwise provided in paragraph

III.B.3.(b)(2) of this appendix A) is the full

amount of the credit enhanced assets from

which risk of credit loss is directly or

indirectly retained or assumed. This credit

equivalent amount is assigned to the risk

weight appropriate to the obligor, or if

relevant, the guarantor or nature of any

collateral. Thus, a bank that extends a partial

direct credit substitute, e.g., a standby letter

of credit that absorbs the first 10 percent of

loss on a transaction, must maintain capital

against the full amount of the assets being

supported. Furthermore, for direct credit

substitutes that are on-balance sheet, e.g.,

purchased subordinated securities, banks

must maintain capital against the amount of

the direct credit substitutes and the full

amounts of the assets being supported, i.e.,

all more senior positions. This treatment is

subject to the low-level recourse rule

discussed in section III.B.3.(c)(1) of this

appendix A. For purposes of this appendix

A, the full amount of the credit enhanced

assets from which risk of credit loss is

directly or indirectly retained or assumed

means for:

(i) A financial guarantee-type standby letter

of credit, surety arrangement, guarantee, or

irrevocable guarantee-type instruments, the

full amount of the assets that the direct credit

substitute fully or partially supports;

(ii) A subordinated interest or security, the

amount of the subordinated interest or

security plus all more senior interests or

securities;

(iii) Mortgage servicing assets that are

recourse obligations or direct credit

substitutes, the outstanding amount of the

loans serviced;

(iv) Representations and warranties (other

than standard representations and

warranties), the amount of the assets subject

to the representations or warranties;

(v) Loans or lines of credit that provide

credit enhancement for the financial

obligations of an account party, the full

amount of the enhanced financial

obligations;

(vi) Loans strips, the amount of the loans;

(vii) For assets sold with recourse, the

amount of assets from which risk of loss is

directly or indirectly retained, less any

applicable recourse liability account

established in accordance with generally

accepted accounting principles; and

(viii) Other types of recourse obligations or

direct credit substitutes should be treated in

accordance with the principles contained in

section III.B.3. of this appendix A.

(2) Determining the credit risk weight of

investment grade recourse obligations, direct

credit substitutes, and asset- and mortgagebacked securities. A traded position is

eligible for the risk-based capital treatment

described in this paragraph if it has been

rated at least investment grade by a

nationally-recognized statistical rating

organization. A recourse obligation or direct

credit substitute that is not a traded position

is eligible for the treatment described in this

paragraph if it has been rated at least

investment grade by two nationallyrecognized statistical rating organizations,

the ratings are publicly available, the ratings

are based on the same criteria used to rate

securities sold to the public, and the recourse

obligation or direct credit substitute provides

credit enhancement to a securitization in

which at least one position is traded.

(i) Highest investment grade. Except as

otherwise provided in this section III. of this

appendix A, the face amount of a recourse

obligation, direct credit substitute, or an

asset- or mortgage-backed security that is

rated in the highest investment grade

category is assigned to the 20 percent risk

category.

(ii) Other investment grade. [Option 1—

Face Value Treatment] Except as otherwise

provided in this section III. of this appendix

A, the face amount of a recourse obligation,

direct credit substitute, or an asset- or

mortgage-backed security that is rated

investment grade is assigned to the 100

percent risk category.

[Option 2—Modified Gross-Up] Except as

otherwise provided in this section III. of this

appendix A, for a recourse obligation, direct

credit substitute, or an asset- or mortgagebacked security that is rated investment

grade, the full amount of the credit enhanced

assets from which risk of credit loss is

directly or indirectly retained or assumed by

the bank is assigned to the 50 percent risk

category, regardless of the face amount of the

bank’s risk position.

(3) Risk participations and syndications in

direct credit substitutes—(i) In the case of

direct credit substitutes in which a risk

participation 23 has been conveyed, the full

amount of the assets that are supported, in

whole or in part, by the credit enhancement

are converted to a credit equivalent amount

at 100 percent. However, the pro rata share

of the credit equivalent amount that has been

conveyed through a risk participation is

assigned to whichever risk category is lower:

the risk category appropriate to the obligor,

after considering any relevant guarantees or

collateral, or the risk category appropriate to

the institution acquiring the participation.24

Any remainder is assigned to the risk

category appropriate to the obligor,

guarantor, or collateral. For example, the pro

rata share of the full amount of the assets

supported, in whole or in part, by a direct

credit substitute conveyed as a risk

participation to a U.S. domestic depository
59966 Federal Register / Vol. 62, No. 214 / Wednesday, November 5, 1997 / Proposed Rules

25Risk participations with a remaining maturity

of over one year that are conveyed to non-OECD

banks are to be assigned to the 100 percent risk

category, unless a lower risk category is appropriate

to the obligor, guarantor, or collateral.

26For example, if a bank has a 10 percent share

of a $10 syndicated direct credit substitute that

provides credit support to a $100 loan, then the

bank’s $1 pro rata share in the enhancement means

that a $10 pro rata share of the loan is included in

risk weighted assets.

27A privately-issued mortgage-backed security

may be treated as an indirect holding of the

underlying assets provided that: (1) The underlying

assets are held by an independent trustee and the

trustee has a first priority, perfected security

interest in the underlying assets on behalf of the

holders of the security; (2) either the holder of the

security has an undivided pro rata ownership

interest in the underlying mortgage assets or the

trust or single purpose entity (or conduit) that

issues the security has no liabilities unrelated to the

issued securities; (3) the security is structured such

that the cash flow from the underlying assets in all

cases fully meets the cash flow requirements of the

security without undue reliance on any

reinvestment income; and (4) there is no material

reinvestment risk associated with any funds

awaiting distribution to the holders of the security.

In addition, if the underlying assets of a mortgagebacked security are composed of more than one

type of assets, for example, U.S. Governmentsponsored agency securities and privately-issued

pass-through securities that qualify for the 50

percent risk category, the entire mortgage-backed

security is generally assigned to the category

appropriate to the highest risk-weighted asset

underlying the issue. Thus, in this example, the

security would receive the 50 percent risk weight

appropriate to the privately-issued pass-through

securities.

39 a. Loans that qualify as loans secured by oneto four-family residential properties or multifamily

residential properties are listed in the instructions

to the commercial bank call report. In addition, for

risk-based capital purposes, loans secured by oneto four-family residential properties include loans

to builders with substantial project equity for the

construction of one-to four-family residences that

have been presold under firm contracts to

purchasers who have obtained firm commitments

for permanent qualifying mortgage loans and have

made substantial earnest-money deposits. b. The

instructions to the call report also discuss the

treatment of loans, including multifamily housing

loans, that are sold subject to a pro rata loss-sharing

arrangement. Such an arrangement should be

treated by the selling bank as sold to the extent that

the sales agreement provides for the purchaser of

the loan to share in any loss incurred on the loan

on a pro rata basis with the selling bank. In such

a transaction, from the stand-point of the selling

bank, the portion of the loan that is treated as sold

is not subject to the risk-based capital standards. In

connection with sales of multifamily housing loans

in which the purchaser of a loan shares in any loss

incurred on the loan with the selling institution on

other than a pro rata basis, the selling bank must

treat these other loss-sharing arrangements in

accordance with section III.B.3. of this appendix A.

42Such assets include all nonlocal-currency

claims on, and the portions of claims that are

guaranteed by, non-OECD central governments and

those portions of local-currency claims on, or

guaranteed by, non-OECD central governments that

exceed the local-currency liabilities held by

subsidiary depository institutions.

43Customer liabilities on acceptances outstanding

involving nonstandard risk claims, such as claims

on U.S. depository institutions, are assigned to the

risk category appropriate to the identity of the

obligor or, if relevant, the nature of the collateral

or guarantees backing the claims. Portions of

acceptances conveyed as risk participations to U.S.

depository institutions or foreign banks are assigned

to the 20 percent risk category appropriate to shortterm claims guaranteed by U.S. depository

institutions and foreign banks.

institution or foreign bank is assigned to the

20 percent risk category.25

(ii) The capital treatment for risk

participations, either conveyed or acquired,

and syndications in direct credit substitutes

that are associated with an asset

securitization and are rated at least

investment grade is set forth in paragraph

III.B.3.(b)(2) of this appendix A. A lower risk

category may be applicable depending upon

the obligor or nature of the institution

acquiring the participation.

(iii) In the case of direct credit substitutes

in which a risk participation has been

acquired, the acquiring bank’s percentage

share of the direct credit substitute is

multiplied by the full amount of the assets

that are supported, in whole or in part, by the

credit enhancement and converted to a credit

equivalent amount at 100 percent. The credit

equivalent amount of an acquisition of a risk

participation in a direct credit substitute is

assigned to the risk category appropriate to

the account party obligor or, if relevant, the

nature of the collateral or guarantees.

(iv) In the case of direct credit substitutes

that take the form of a syndication where

each bank is obligated only for its pro rata

share of the risk and there is no recourse to

the originating bank, each bank will only

include its pro rata share of the assets

supported, in whole or in part, by the direct

credit substitute in its risk-based capital

calculation.26

(c) Limitations on risk-based capital

requirements—(1) Low-level recourse. If the

maximum contractual liability or exposure to

loss retained or assumed by a bank in

connection with a recourse obligation or a

direct credit substitute is less than the

effective risk-based capital requirement for

the enhanced assets, the risk-based capital

requirement is limited to the maximum

contractual liability or exposure to loss, less

any recourse liability account established in

accordance with generally accepted

accounting principles. This limitation does

not apply to assets sold with implicit

recourse.

(2) Mortgage-related securities or

participation certificates retained in a

mortgage loan swap. If a bank holds a

mortgage-related security or a participation

certificate as a result of a mortgage loan swap

with recourse, capital is required to support

the recourse obligation plus the percentage of

the mortgage-related security or participation

certificate that is not covered by the recourse

obligation. The total amount of capital

required for the on-balance sheet asset and

the recourse obligation, however, is limited

to the capital requirement for the underlying

loans, calculated as if the bank continued to

hold these loans as an on-balance sheet asset.

(3) Related on-balance sheet assets. If a

recourse obligation or direct credit substitute

subject to this section III.B.3. of this

appendix A also appears as a balance sheet

asset, the balance sheet asset is not included

in a bank’s risk-weighted assets, except in the

case of mortgage servicing assets and similar

arrangements with embedded recourse

obligations or direct credit substitutes. In

such cases, both the on-balance sheet assets

and the related recourse obligations and

direct credit substitutes are incorporated into

the risk-based capital calculation.

(d) Privately-issued mortgage-backed

securities. Generally, a privately-issued

mortgage-backed security meeting certain

criteria, set forth in the accompanying

footnote,27 is essentially treated as an indirect

holding of the underlying assets, and

assigned to the same risk category as the

underlying assets, but in no case to the zero

percent risk category. However, any class of

a privately-issued mortgage-backed security

whose structure does not qualify it to be

regarded as an indirect holding of the

underlying assets or that can absorb more

than its pro rata share of loss without the

whole issue being in default (for example, a

so-called subordinated class) is treated in

accordance with section III.B.3.(b) of this

appendix A. Furthermore, all stripped

mortgage-backed securities, including

interest-only strips (IOs), principal-only

strips (POs), and similar instruments, are

assigned to the 100 percent risk weight

category, regardless of the issuer or

guarantor.

* * * * *

3. In appendix A to part 208, sections

III.C.1. through 3., footnotes 25 through

37 are redesignated as footnotes 29

through 41 and newly redesignated

footnote 39 and section III.C.4. are

revised to read as follows:

* * * * *

III. * * *

C. * * *

3. * * * 39 * * *

* * * * *

4. Category 4: 100 percent. (a) All assets

not included in the categories above are

assigned to this category, which comprises

standard risk assets. The bulk of the assets

typically found in a loan portfolio would be

assigned to the 100 percent category.

(b) This category includes long-term claims

on, and the portions of long-term claims that

are guaranteed by, non-OECD banks, and all

claims on non-OECD central governments

that entail some degree of transfer risk.42 This

category includes all claims on foreign and

domestic private-sector obligors not included

in the categories above (including loans to

nondepository financial institutions and

bank holding companies); claims on

commercial firms owned by the public

sector; customer liabilities to the bank on

acceptances outstanding involving standard

risk claims;43 investments in fixed assets,

premises, and other real estate owned;

common and preferred stock of corporations,

including stock acquired for debts previously

contracted; commercial and consumer loans

(except those assigned to lower risk

categories due to recognized guarantees or

collateral and loans secured by residential

property that qualify for a lower risk weight);

and all stripped mortgage-backed securities

and similar instruments.

(c) Also included in this category are

industrial-development bonds and similar

obligations issued under the auspices of state

or political subdivisions of the OECD-based
Federal Register / Vol. 62, No. 214 / Wednesday, November 5, 1997 / Proposed Rules 59967

44The sufficiency of collateral and guarantees for

off-balance-sheet items is determined by the market

value of the collateral of the amount of the

guarantee in relation to the face amount of the item,

except for derivative contracts, for which this

determination is generally made in relation to the

credit equivalent amount. Collateral and guarantees

are subject to the same provisions noted under

section III.B. of this appendix A.

45Forward forward deposits accepted are treated

as interest rate contracts.

group of countries for the benefit of a private

party or enterprise where that party or

enterprise, not the government entity, is

obligated to pay the principal and interest,

and all obligations of states or political

subdivisions of countries that do not belong

to the OECD-based group.

(d) The following assets also are assigned

a risk weight of 100 percent if they have not

been deducted from capital: investments in

unconsolidated companies, joint ventures, or

associated companies; instruments that

qualify as capital issued by other banking

organizations; and any intangibles, including

those that may have been grandfathered into

capital.

* * * * *

4. In appendix A to part 208, the

introductory paragraph in section III.D.

and section III.D.1. are revised to read

as follows:

* * * * *

III. * * *

D. Off-Balance Sheet Items

The face amount of an off-balance sheet

item is generally incorporated into riskweighted assets in two steps. The face

amount is first multiplied by a credit

conversion factor, except for direct credit

substitutes and recourse obligations as

discussed in section III.D.1. of this appendix

A. The resultant credit equivalent amount is

assigned to the appropriate risk category

according to the obligor or, if relevant, the

guarantor or the nature of the collateral.44

Attachment IV to this appendix A sets forth

the conversion factors for various types of

off-balance-sheet items.

1. Items with a 100 percent conversion

factor. (a) Except as otherwise provided in

section III.B.3. of this appendix A, the full

amount of an asset or transaction supported,

in whole or in part, by a direct credit

substitute or a recourse obligation. Direct

credit substitutes and recourse obligations

are defined in section III.B.3. of this

appendix A.

(b) Sale and repurchase agreements, if not

already included on the balance sheet, and

forward agreements. Forward agreements are

legally binding contractual obligations to

purchase assets with certain drawdown at a

specified future date. Such obligations

include forward purchases, forward forward

deposits placed,45 and partly-paid shares and

securities; they do not include commitments

to make residential mortgage loans or

forward foreign exchange contracts.

(c) Securities lent by a bank are treated in

one of two ways, depending upon whether

the lender is at risk of loss. If a bank, as agent

for a customer, lends the customer’s

securities and does not indemnify the

customer against loss, then the transaction is

excluded from the risk-based capital

calculation. If, alternatively, a bank lends its

own securities or, acting as agent for a

customer, lends the customer’s securities and

indemnifies the customer against loss, the

transaction is converted at 100 percent and

assigned to the risk weight category

appropriate to the obligor or, if applicable to

any collateral delivered to the lending bank

the independent custodian acting on the

lending bank’s behalf. Where a bank is acting

as agent for a customer in a transaction

involving the lending or sale of securities

that is collateralized by cash delivered to the

bank, the transaction is deemed to be

collateralized by cash on deposit in the bank

for purposes of determining the appropriate

risk-weight category, provided that any

indemnification is limited to no more than

the difference between the market value of

the securities and the cash collateral received

and any reinvestment risk associated with

that cash collateral is borne by the customer.

* * * * *

PART 225—BANK HOLDING

COMPANIES AND CHANGE IN BANK

CONTROL (REGULATION Y)

1. The authority citation for part 225

continues to read as follows:

Authority: 12 U.S.C. 1817(j)(13), 1818,

1828(o), 1831i, 1831p–1, 1843(c)(8), 1844(b),

1972(1), 3106, 3108, 3310, 3331–3351, 3907,

and 3909.

2. In appendix A to part 225, section

III.B. is amended by revising paragraph

3. and in paragraph 4., footnote 27 is

redesignated as footnote 31. The

revision reads as follows:

Appendix A to Part 225—Capital

Adequacy Guidelines for Bank Holding

Companies: Risk-Based Measure

* * * * *

III. * * *

B.* * *

3. Recourse obligations, direct credit

substitutes, and asset- and mortgage-backed

securities. Direct credit substitutes, assets

transferred with recourse, and securities

issued in connection with asset

securitizations are treated as described

below.

(a) Definitions—(1) Direct credit substitute

means an arrangement in which a banking

organization assumes, in form or in

substance, any risk of credit loss directly or

indirectly associated with a third-party asset

or other financial claim, that exceeds the

banking organization’s pro rata share of the

asset or claim. If the banking organization has

no claim on the asset, then the assumption

of any risk of loss is a direct credit substitute.

Direct credit substitutes include, but are not

limited to:

(i) Financial guarantee-type standby letters

of credit that support financial claims on the

account party;

(ii) Guarantees, surety arrangements, and

irrevocable guarantee-type instruments

backing financial claims such as outstanding

securities, loans, or other financial liabilities,

or that back off-balance-sheet items against

which risk-based capital must be maintained;

(iii) Purchased subordinated interests or

securities that absorb more than their pro

rata share of losses from the underlying

assets;

(iv) Loans or lines of credit that provide

credit enhancement for the financial

obligations of an account party; and

(v) Purchased loan servicing assets if the

servicer is responsible for credit losses

associated with the loans being serviced

(other than mortgage servicer cash advances

as defined in paragraph III.B.3.(a)(3) of this

appendix A), or if the servicer makes or

assumes representations and warranties on

the loans other than standard representations

and warranties as defined in paragraph

III.B.3.(a)(6) of this appendix A.

(2) Financial guarantee-type standby letter

of credit means any letter of credit or similar

arrangement, however named or described,

that represents an irrevocable obligation to

the beneficiary on the part of the issuer:

(i) To repay money borrowed by, advanced

to, or for the account of, the account party;

or

(ii) To make payment on account of any

indebtedness undertaken by the account

party in the event that the account party fails

to fulfill its obligation to the beneficiary.

(3) Mortgage servicer cash advance means

funds that a residential mortgage loan

servicer advances to ensure an uninterrupted

flow of payments or the timely collection of

residential mortgage loans, including

disbursements made to cover foreclosure

costs or other expenses arising from a

mortgage loan to facilitate its timely

collection. A servicer cash advance is not a

recourse obligation or a direct credit

substitute if the mortgage servicer is entitled

to full reimbursement or, for any one

residential mortgage loan, nonreimbursable

advances are contractually limited to an

insignificant advances of the outstanding

principal on that loan.

(4) Rated means, with respect to an

instrument or obligation, that the instrument

or obligation has received a credit rating from

a nationally-recognized statistical rating

organization. An instrument or obligation is

rated investment grade if it has received a

credit rating that falls within one of the four

highest rating categories used by the

organization. An instrument or obligation is

rated in the highest investment grade if it has

received a credit rating that falls within the

highest rating category used by the

organization.

(5) Recourse means an arrangement in

which a banking organization retains, in form

or in substance, any risk of credit loss

directly or indirectly associated with a

transferred asset that exceeds a pro rata share

of the banking organization’s claim on the

asset. If a banking organization has no claim

on a transferred asset, then the retention of

any risk of loss is recourse. A recourse

obligation typically arises when an

institution transfers assets and retains an

obligation to repurchase the assets or absorb

losses due to a default of principal or interest

or any other deficiency in the performance of

the underlying obligor or some other party.

Recourse may exist implicitly where a

banking organization provides credit

enhancement beyond any contractual
59968 Federal Register / Vol. 62, No. 214 / Wednesday, November 5, 1997 / Proposed Rules

26That is, a participation in which the originating

banking organization remains liable to the

beneficiary for the full amount of the direct credit

substitute if the party that has acquired the

participation fails to pay when the instrument is

drawn.

27A risk participation in bankers acceptances

conveyed to other institutions is also assigned to

the risk category appropriate to the institution

acquiring the participation or, if relevant, the

guarantor or nature of the collateral.

28Risk participations with a remaining maturity

of over one year that are conveyed to non-OECD

banks are to be assigned to the 100 percent risk

category, unless a lower risk category is appropriate

to the obligor, guarantor, or collateral.

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 banking organization extends when it

transfers assets (including loan servicing

assets) or assumes when it purchases loan

servicing assets. To qualify as a standard

representation or warranty, a contractual

provision must:

(i) Refer to facts that the seller or servicer

can verify, and has verified with reasonable

due diligence, prior to the time that assets are

transferred (or servicing assets are acquired);

(ii) Refer to a condition that is within the

control of the seller or servicer; or

(iii) Provide for the return of assets in the

event of fraud or documentation deficiencies.

(7) Traded position means a recourse

obligation, direct credit substitute, or assetor mortgage-backed security that is retained,

assumed, or issued in connection with an

asset securitization and that is rated with a

reasonable expectation that, in the near

future:

(i) The position would be sold to investors

relying on the rating; or

(ii) A third party would, in reliance on the

rating, enter into a transaction such as a

purchase, loan, or repurchase agreement

involving the position.

(b) Amount of position to be included in

risk-weighted assets—(1) Determining the

credit equivalent amount of recourse

obligations and direct credit substitutes. The

credit equivalent amount for a recourse

obligation or direct credit substitute (except

as otherwise provided in paragraph

III.B.3.(b)(2) of this appendix A) is the full

amount of the credit enhanced assets from

which risk of credit loss is directly or

indirectly retained or assumed. This credit

equivalent amount is assigned to the risk

weight appropriate to the obligor, or if

relevant, the guarantor or nature of any

collateral. Thus, a banking organization that

extends a partial direct credit substitute, e.g.,

a standby letter of credit that absorbs the first

10 percent of loss on a transaction, must

maintain capital against the full amount of

the assets being supported. Furthermore, for

direct credit substitutes that are on-balance

sheet, e.g., purchased subordinated

securities, banking organizations must

maintain capital against the amount of the

direct credit substitutes and the full amounts

of the assets being supported, i.e., all more

senior positions. This treatment is subject to

the low-level recourse rule discussed in

paragraph III.B.3.(c)(1) of this appendix A.

For purposes of this appendix A, the full

amount of the credit enhanced assets from

which risk of credit loss is directly or

indirectly retained or assumed means for:

(i) A financial guarantee-type standby letter

of credit, surety arrangement, guarantee, or

irrevocable guarantee-type instruments, the

full amount of the assets that the direct credit

substitute fully or partially supports;

(ii) A subordinated interest or security, the

amount of the subordinated interest or

security plus all more senior interests or

securities;

(iii) Mortgage servicing assets that are

recourse obligations or direct credit

substitutes, the outstanding amount of the

loans serviced;

(iv) Representations and warranties (other

than standard representations and

warranties), the amount of the assets subject

to the representations or warranties;

(v) Loans or lines of credit that provide

credit enhancement for the financial

obligations of an account party, the full

amount of the enhanced financial

obligations;

(vi) Loans strips, the amount of the loans;

(vii) For assets sold with recourse, the

amount of assets from which risk of loss is

directly or indirectly retained, less any

applicable recourse liability account

established in accordance with generally

accepted accounting principles; and

(viii) Other types of recourse obligations or

direct credit substitutes should be treated in

accordance with the principles contained in

paragraph III.B.3.(b)(3) of this appendix A.

(2) Determining the credit risk weight of

investment grade recourse obligations, direct

credit substitutes, and asset- and mortgagebacked securities. A traded position is

eligible for the risk-based capital treatment

described in this paragraph if it has been

rated at least investment grade by a

nationally-recognized statistical rating

organization. A recourse obligation or direct

credit substitute that is not a traded position

is eligible for the treatment described in this

paragraph if it has been rated at least

investment grade by two nationallyrecognized statistical rating organizations,

the ratings are publicly available, the ratings

are based on the same criteria used to rate

securities sold to the public, and the recourse

obligation or direct credit substitute provides

credit enhancement to a securitization in

which at least one position is traded.

(i) Highest investment grade. Except as

otherwise provided in section III. of this

appendix A, the face amount of a recourse

obligation, direct credit substitute, or an

asset- or mortgage-backed security that is

rated in the highest investment grade

category is assigned to the 20 percent risk

category.

(ii) Other investment grade. [Option 1—

Face Value Treatment] Except as otherwise

provided in this section III. of this appendix

A, the face amount of a recourse obligation,

direct credit substitute, or an asset- or

mortgage-backed security that is rated

investment grade is assigned to the 100

percent risk category.

[Option 2—Modified Gross-Up] Except as

otherwise provided in section III. of this

appendix A, for a recourse obligation, direct

credit substitute, or an asset or mortgagebacked security that is rated investment

grade, the full amount of the credit enhanced

assets from which risk of credit loss is

directly or indirectly retained or assumed by

the banking organization is assigned to the 50

percent risk category, regardless of the face

amount of the banking organization’s risk

position.

(3) Risk participations and syndications in

direct credit substitutes—(i) In the case of

direct credit substitutes in which a risk

participation 26 has been conveyed, the full

amount of the assets that are supported, in

whole or in part, by the credit enhancement

are converted to a credit equivalent amount

at 100 percent. However, the pro rata share

of the credit equivalent amount that has been

conveyed through a risk participation is

assigned to whichever risk category is lower:

the risk category appropriate to the obligor,

after considering any relevant guarantees or

collateral, or the risk category appropriate to

the institution acquiring the participation.27

Any remainder is assigned to the risk

category appropriate to the obligor,

guarantor, or collateral. For example, the pro

rata share of the full amount of the assets

supported, in whole or in part, by a direct

credit substitute conveyed as a risk

participation to a U.S. domestic depository

institution or foreign bank is assigned to the

20 percent risk category.28

(ii) The capital treatment for risk

participations, either conveyed or acquired,

and syndications in direct credit substitutes

that are associated with an asset

securitization and are rated at least

investment grade is set forth in paragraph

III.B.3.(b)(2) of this appendix A. A lower risk

category may be applicable depending upon

the obligor or nature of the institution

acquiring the participation.

(iii) In the case of direct credit substitutes

in which a risk participation has been

acquired, the acquiring banking

organization’s percentage share of the direct

credit substitute is multiplied by the full

amount of the assets that are supported, in

whole or in part, by the credit enhancement

and converted to a credit equivalent amount

at 100 percent. The credit equivalent amount

of an acquisition of a risk participation in a

direct credit substitute is assigned to the risk

category appropriate to the account party

obligor or, if relevant, the nature of the

collateral or guarantees.
Federal Register / Vol. 62, No. 214 / Wednesday, November 5, 1997 / Proposed Rules 59969

29For example, if a banking organization has a 10

percent share of a $10 syndicated direct credit

substitute that provides credit support to a $100

loan, then the banking organization $1 pro rata

share in the enhancement means that a $10 pro rata

share of the loan is included in risk-weighted

assets.

30A privately-issued mortgage-backed security

may be treated as an indirect holding of the

underlying assets provided that: (1) the underlying

assets are held by an independent trustee and the

trustee has a first priority, perfected security

interest in the underlying assets on behalf of the

holders of the security; (2) either the holder of the

security has an undivided pro rata ownership

interest in the underlying mortgage assets or the

trust or single purpose entity (or conduit) that

issues the security has no liabilities unrelated to the

issued securities; (3) the security is structured such

that the cash flow from the underlying assets in all

cases fully meets the cash flow requirements of the

security without undue reliance on any

reinvestment income; and (4) there is no material

reinvestment risk associated with any funds

awaiting distribution to the holders of the security.

In addition, if the underlying assets of a mortgagebacked security are composed of more than one

type of assets, for example, U.S. Governmentsponsored agency securities and privately-issued

pass-through securities that qualify for the 50

percent risk category, the entire mortgage-backed

security is generally assigned to the category

appropriate to the highest risk-weighted asset

underlying the issue. Thus, in this example, the

security would receive the 50 percent risk weight

appropriate to the privately-issued pass-through

securities.

45Such assets include all nonlocal currency

claims on, and the portions of claims that are

guaranteed by, non-OECD central governments and

those portions of local currency claims on, or

guaranteed by, non-OECD central governments that

exceed the local currency liabilities held by

subsidiary depository institutions.

46Customer liabilities on acceptances outstanding

involving nonstandard risk claims, such as claims

on U.S. depository institutions, are assigned to the

risk category appropriate to the identity of the

obligor or, if relevant, the nature of the collateral

or guarantees backing the claims. Portions of

acceptances conveyed as risk participations to U.S.

depository institutions or foreign banks are assigned

to the 20 percent risk category appropriate to shortterm claims guaranteed by U.S. depository

institutions and foreign banks.

47The sufficiency of collateral and guarantees for

off-balance-sheet items is determined by the market

value of the collateral of the amount of the

guarantee in relation to the face amount of the item,

except for derivative contracts, for which this

determination is generally made in relation to the

credit equivalent amount. Collateral and guarantees

are subject to the same provisions noted under

section III.B. of this appendix A.

(iv) In the case of direct credit substitutes

that take the form of a syndication where

each banking organization is obligated only

for its pro rata share of the risk and there is

no recourse to the originating banking

organization, each banking organization will

only include its pro rata share of the assets

supported, in whole or in part, by the direct

credit substitute in its risk-based capital

calculation.29

(c) Limitations on risk-based capital

requirements—(1) Low-level recourse. If the

maximum contractual liability or exposure to

loss retained or assumed by a banking

organization in connection with a recourse

obligation or a direct credit substitute is less

than the effective risk-based capital

requirement for the enhanced assets, the riskbased capital requirement is limited to the

maximum contractual liability or exposure to

loss, less any recourse liability account

established in accordance with generally

accepted accounting principles. This

limitation does not apply to assets sold with

implicit recourse.

(2) Mortgage-related securities or

participation certificates retained in a

mortgage loan swap. If a banking

organization holds a mortgage-related

security or a participation certificate as a

result of a mortgage loan swap with recourse,

capital is required to support the recourse

obligation plus the percentage of the

mortgage-related security or participation

certificate that is not covered by the recourse

obligation. The total amount of capital

required for the on-balance sheet asset and

the recourse obligation, however, is limited

to the capital requirement for the underlying

loans, calculated as if the banking

organization continued to hold these loans as

an on-balance sheet asset.

(3) Related on-balance sheet assets. If a

recourse obligation or direct credit substitute

subject to section III.B.3. of this appendix A

also appears as a balance sheet asset, the

balance sheet asset is not included in a

banking organization’s risk-weighted assets,

except in the case of mortgage servicing

assets and similar arrangements with

embedded recourse obligations or direct

credit substitutes. In such cases, both the onbalance sheet assets and the related recourse

obligations and direct credit substitutes are

incorporated into the risk-based capital

calculation.

(d) Privately-issued mortgage-backed

securities. Generally, a privately-issued

mortgage-backed security meeting certain

criteria, set forth in the accompanying

footnote,30 is essentially treated as an indirect

holding of the underlying assets, and

assigned to the same risk category as the

underlying assets, but in no case to the zero

percent risk category. However, any class of

a privately-issued mortgage-backed security

whose structure does not qualify it to be

regarded as an indirect holding of the

underlying assets or that can absorb more

than its pro rata share of loss without the

whole issue being in default (for example, a

so-called subordinated class) is treated in

accordance with section III.B.3.(b) of this

appendix A. Furthermore, all stripped

mortgage-backed securities, including (IOs),

principal-only strips (POs), and similar

instruments, are assigned to the 100 percent

risk weight category, regardless of the issuer

or guarantor.

* * * * *

3. In appendix A to part 225, sections

III.C.1. through 3., footnotes 28 through

40 are redesignated as footnotes 32

through 44 and section III.C.4. is revised

to read as follows:

* * * * *

III. * * *

C. * * *

4. Category 4: 100 percent. (a) All assets

not included in the categories above are

assigned to this category, which comprises

standard risk assets. The bulk of the assets

typically found in a loan portfolio would be

assigned to the 100 percent category.

(b) This category includes long-term claims

on, and the portions of long-term claims that

are guaranteed by, non-OECD banks, and all

claims on non-OECD central governments

that entail some degree of transfer risk.45 This

category includes all claims on foreign and

domestic private-sector obligors not included

in the categories above (including loans to

nondepository financial institutions and

bank holding companies); claims on

commercial firms owned by the public

sector; customer liabilities to the bank on

acceptances outstanding involving standard

risk claims; 46 investments in fixed assets,

premises, and other real estate owned;

common and preferred stock of corporations,

including stock acquired for debts previously

contracted; commercial and consumer loans

(except those assigned to lower risk

categories due to recognized guarantees or

collateral and loans secured by residential

property that qualify for a lower risk weight);

and all stripped mortgage-backed securities

and similar instruments.

(c) Also included in this category are

industrial-development bonds and similar

obligations issued under the auspices of state

or political subdivisions of the OECD-based

group of countries for the benefit of a private

party or enterprise where that party or

enterprise, not the government entity, is

obligated to pay the principal and interest,

and all obligations of states or political

subdivisions of countries that do not belong

to the OECD-based group.

(d) The following assets also are assigned

a risk weight of 100 percent if they have not

been deducted from capital: investments in

unconsolidated companies, joint ventures, or

associated companies; instruments that

qualify as capital issued by other banking

organizations; and any intangibles, including

those that may have been grandfathered into

capital.

* * * * *

4. In appendix A to part 225, the

introductory paragraph and paragraph 1.

in section III.D. are revised and footnote

49 is added and reserved to read as

follows:

* * * * *

III. * * *

D. Off-Balance Sheet Items

The face amount of an off-balance sheet

item is generally incorporated into the riskweighted assets in two steps. The face

amount is first multiplied by a credit

conversion factor, except for direct credit

substitutes and recourse obligations as

discussed in paragraph III.D.1. of this

appendix A. The resultant credit equivalent

amount is assigned to the appropriate risk

category according to the obligor or, if

relevant, the guarantor or the nature of the

collateral.47 Attachment IV to this appendix

A sets forth the conversion factors for various

types of off-balance-sheet items.

1. Items with a 100 percent conversion

factor. (a) Except as otherwise provided in

paragraph III.B.3. of this appendix A, the full

amount of an asset or transaction supported,

in whole or in part, by a direct credit
59970 Federal Register / Vol. 62, No. 214 / Wednesday, November 5, 1997 / Proposed Rules

48Forward forward deposits accepted are treated

as interest rate contracts.

substitute or a recourse obligation. Direct

credit substitutes and recourse obligations

are defined in paragraph III.B.3. of this

appendix A.

(b) Sale and repurchase agreements, if not

already included on the balance sheet, and

forward agreements. Forward agreements are

legally binding contractual obligations to

purchase assets with certain drawdown at a

specified future date. Such obligations

include forward purchases, forward forward

deposits placed,48 and partly-paid shares and

securities; they do not include commitments

to make residential mortgage loans or

forward foreign exchange contracts.

(c) Securities lent by a banking

organization are treated in one of two ways,

depending upon whether the lender is at risk

of loss. If a banking organization, as agent for

a customer, lends the customer’s securities

and does not indemnify the customer against

loss, then the transaction is excluded from

the risk-based capital calculation. If,

alternatively, a bank lends its own securities

or, acting as agent for a customer, lends the

customer’s securities and indemnifies the

customer against loss, the transaction is

converted at 100 percent and assigned to the

risk weight category appropriate to the

obligor or, if applicable, to any collateral

delivered to the lending banking organization

or the independent custodian acting on the

lending banking organization’s behalf. Where

a banking organization is acting as agent for

a customer in a transaction involving the

lending or sale of securities that is

collateralized by cash delivered to the

banking organization, the transaction is

deemed to be collateralized by cash on

deposit in the banking organization for

purposes of determining the appropriate riskweight category, provided that any

indemnification is limited to no more than

the difference between the market value of

the securities and the cash collateral received

and any reinvestment risk associated with

that cash collateral is borne by the customer.

* * * * *

By order of the Board of Governors of the

Federal Reserve System, October 21, 1997.

William W. Wiles,

Secretary of the Board.

Federal Deposit Insurance Corporation

12 CFR CHAPTER III

Authority and Issuance

For the reasons set forth in the joint

preamble, part 325 of chapter III of title

12 of the Code of Federal Regulations is

proposed to be amended as follows:

PART 325—CAPITAL MAINTENANCE

1. The authority citation for part 325

continues to read as follows:

Authority: 12 U.S.C. 1815(a), 1815(b),

1816, 1818(a), 1818(b), 1818(c), 1818(t),

1819(Tenth), 1828(c), 1828(d), 1828(i),

1828(n), 1828(o), 1831o, 3907, 3909, 4808;

Pub. L. 102–233, 105 Stat. 1761, 1789, 1790

(12 U.S.C. 1831n note); Pub. L. 102-242, 105

Stat. 2236, 2355, 2386 (12 U.S.C. 1828 note).

2. In appendix A to part 325, section

II.B. is amended by revising paragraph

5. to read as follows:

Appendix A to Part 325—Statement of

Policy on Risk-Based Capital

* * * * *

II. Procedures for Computing Risk-Weighted

Assets

* * * * *

B. * * *

5. Recourse obligations, direct credit

substitutes, and asset-and mortgage-backed

securities. Direct credit substitutes, assets

transferred with recourse, and securities

issued in connection with asset

securitizations are treated as described in

paragraphs B.5.(b) through (e) of this section.

(a) Definitions. (i) Direct credit substitute

means an arrangement in which a bank

assumes, in form or in substance, any risk of

credit loss directly or indirectly associated

with a third-party asset or other financial

claim, that exceeds the bank’s pro rata share

of the asset or claim. If the bank has no claim

on the asset, then the assumption of any risk

of loss is a direct credit substitute. Direct

credit substitutes include, but are not limited

to:

(1) Financial guarantee-type standby letters

of credit that support financial claims on the

account party;

(2) Guarantees, surety arrangements, and

irrevocable guarantee-type instruments

backing financial claims such as outstanding

securities, loans, or other financial liabilities,

or that back off-balance-sheet items against

which risk-based capital must be maintained;

(3) Purchased subordinated interests or

securities that absorb more than their pro rata

share of losses from the underlying assets;

(4) Loans or lines of credit that provide

credit enhancement for the financial

obligations of an account party; and

(5) Purchased loan servicing assets if the

servicer is responsible for credit losses

associated with the loans being serviced

(other than mortgage servicer cash advances

as defined in paragraph B.5.(a)(iii) of this

section), or if the servicer makes or assumes

representations and warranties on the loans

other than standard representations and

warranties as defined in paragraph

B.5.(a)(vii) of this section.

(ii) Financial guarantee-type standby letter

of credit means any letter of credit or similar

arrangement, however named or described,

that represents an irrevocable obligation to

the beneficiary on the part of the issuer:

(1) To repay money borrowed by, advanced

to, or for the account of, the account party;

or

(2) To make payment on account of any

indebtedness undertaken by the account

party in the event that the account party fails

to fulfill its obligation to the beneficiary.

(iii) Mortgage servicer cash advance means

funds that a residential mortgage loan

servicer advances to ensure an uninterrupted

flow of payments or the timely collection of

residential mortgage loans, including

disbursements made to cover foreclosure

costs or other expenses arising from a

mortgage loan to facilitate its timely

collection. A servicer cash advance is not a

recourse obligation or a direct credit

substitute if the mortgage servicer is entitled

to full reimbursement or, for any one

residential mortgage loan, nonreimbursable

advances are contractually limited to an

insignificant amount of the outstanding

principal on that loan.

(iv) Nationally recognized statistical rating

organization means an entity recognized by

the Division of Market Regulation of the

Securities and Exchange Commission as a

nationally recognized statistical rating

organization for various purposes, including

the Commission’s uniform net capital

requirements for brokers or dealers (17 CFR

240.15c3–1(c)(2)(vi)(E), (F), and (H)).

(v) Rated means a recourse obligation,

direct credit substitute, or asset-or mortgagebacked security that is retained, assumed, or

issued in connection with an asset

securitization and that has received a credit

rating from a nationally recognized statistical

rating organization. A position is rated

investment grade if it has received a credit

rating that falls within one of the four highest

rating categories used by the organization

(e.g., at least ‘‘BBB’’ or its equivalent). A

position is rated in the highest investment

grade if it has received a credit rating that

falls within the highest rating category used

by the organization.

(vi) Recourse means an arrangement in

which a bank retains, in form or in substance,

any risk of credit loss directly or indirectly

associated with a transferred asset that

exceeds a pro rata share of the bank’s claim

on the asset. If a bank has no claim on a

transferred asset, then the retention of any

risk of loss is recourse. A recourse obligation

typically arises when an institution transfers

assets and retains an obligation to repurchase

the assets or absorb losses due to a default

of principal or interest or any other

deficiency in the performance of the

underlying obligor or some other party.

Recourse may exist implicitly where a bank

provides credit enhancement beyond any

contractual obligation to support assets it has

sold. Recourse obligations include, but are

not limited to:

(1) Representations and warranties on the

transferred assets other than standard

representations and warranties as defined in

paragraph B.5.(a)(vii) of this section;

(2) Retained loan servicing assets if the

servicer is responsible for losses associated

with the loans being serviced other than

mortgage servicer cash advances as defined

in paragraph B.5.(a)(iii) of this section;

(3) Retained subordinated interests or

securities that absorb more than their pro

rata share of losses from the underlying

assets;

(4) Assets sold under an agreement to

repurchase; and

(5) Loan strips sold without direct recourse

where the maturity of the transferred loan

that is drawn is shorter than the maturity of

the commitment.

(vii) Standard representations and

warranties means contractual assurances

regarding the nature, quality, and condition

of assets that a bank extends when it transfers
Federal Register / Vol. 62, No. 214 / Wednesday, November 5, 1997 / Proposed Rules 59971

14That is, a participation in which the originating

bank remains liable to the beneficiary for the full

amount of the direct credit substitute if the party

that has acquired the participation fails to pay when

the instrument is drawn.

15A risk participation in a bankers acceptance

conveyed to another institution is also assigned to

the risk category appropriate to the institution

acquiring the participation or, if relevant, the

guarantor or nature of the collateral.

16A risk participation with a remaining maturity

of over one year that is conveyed to a non-OECD

bank is to be assigned to the 100 percent risk

category, unless a lower risk category is appropriate

to the obligor, guarantor, or collateral.

17For example, if a bank has a 10 percent share

of a $10 syndicated direct credit substitute that

provides credit support to a $100 loan, then the

bank’s $1 pro rata share in the enhancement means

that a $10 pro rata share of the loan is included in

risk-weighted assets.

assets (including loan servicing assets) or

assumes when it purchases loan servicing

assets, but only to the extent that the

assurances:

(1) Refer to facts that the seller or servicer

can verify, and has verified with reasonable

due diligence, prior to the time that assets are

transferred (or servicing assets are acquired);

(2) Refer to a condition that is within the

control of the seller or servicer; or

(3) Provide for the return of assets in the

event of fraud or documentation deficiencies.

(viii) Traded position means a recourse

obligation, direct credit substitute, or asset-or

mortgage-backed security that is retained,

assumed, or issued in connection with an

asset securitization and that is rated with a

reasonable expectation that, in the near

future:

(1) The position would be sold to investors

relying on the rating; or

(2) A third party would, in reliance on the

rating, enter into a transaction such as a

purchase, loan, or repurchase agreement

involving the position.

(b) Amount of position to be included in

risk-weighted assets. (i) General rule. The

credit equivalent amount for a recourse

obligation or direct credit substitute is the

full amount of the credit enhanced assets

from which risk of credit loss is directly or

indirectly retained or assumed. This credit

equivalent amount is assigned to the risk

weight appropriate to the obligor or, if

relevant, the guarantor or nature of any

collateral. For purposes of this appendix A,

the full amount of the credit enhanced assets

from which risk of credit loss is directly or

indirectly retained or assumed means for:

(1) A financial guarantee-type standby

letter of credit, surety arrangement,

guarantee, or irrevocable guarantee-type

instruments, the full amount of the assets

that the direct credit substitute fully or

partially supports;

(2) A subordinated interest or security, the

amount of the subordinated interest or

security plus all more senior interests or

securities;

(3) Mortgage servicing assets that are

recourse obligations or direct credit

substitutes, the outstanding amount of the

loans serviced;

(4) Representations and warranties (other

than standard representations and

warranties), the amount of the assets subject

to the representations or warranties;

(5) Loans or lines of credit that provide

credit enhancement for the financial

obligations of an account party, the full

amount of the enhanced financial

obligations;

(6) Loans strips, the amount of the loans;

and

(7) For assets sold with recourse, the

amount of assets from which risk of loss is

directly or indirectly retained, less any

applicable recourse liability account

established in accordance with generally

accepted accounting principles.

For example, a bank that extends a partial

direct credit substitute, e.g., a financial

guarantee-type standby letter of credit that

absorbs the first 10 percent of loss on a

transaction, must maintain capital against the

full amount of the assets being supported.

Furthermore, for a recourse obligation or a

direct credit substitute that is an on-balance

sheet asset, e.g., a retained or purchased

subordinated security, a bank must maintain

capital against the amount of the on-balance

sheet asset plus the full amount of the assets

not on the bank’s balance sheet that are being

supported, i.e., all more senior positions.

(ii) Determining the credit risk weight of

investment grade recourse obligations, direct

credit substitutes, and asset- and mortgagebacked securities. Notwithstanding

paragraph B.5.(b)(i) of this section, a traded

position is eligible for the following riskbased capital treatment. A recourse

obligation or direct credit substitute that is

not a traded position also is eligible for the

following treatment if it has been rated at

least investment grade by two nationally

recognized statistical rating organizations,

the ratings are publicly available, the ratings

are based on the same criteria used to rate

securities sold to the public, and the recourse

obligation or direct credit substitute provides

credit enhancement to a securitization in

which there is at least one traded position.

(1) Highest investment grade. The face

amount of a recourse obligation, direct credit

substitute, or an asset- or mortgage-backed

security that is rated in the highest

investment grade category is assigned to the

20 percent risk category.

(2) Other investment grade. [Option 1—

Face Value Treatment] The face amount of a

recourse obligation, direct credit substitute,

or an asset- or mortgage-backed security that

is rated investment grade (but not in the

highest investment grade category) is

assigned to the 100 percent risk category.

[Option 2—Modified Gross-Up] For a

recourse obligation, direct credit substitute,

or an asset- or mortgage-backed security that

is rated investment grade (but not in the

highest investment grade category), the full

amount of the credit enhanced assets from

which risk of credit loss is directly or

indirectly retained or assumed by the bank is

assigned to the 50 percent risk category,

regardless of the face amount of the bank’s

risk position. For a senior asset-or mortgagebacked security which provides no credit

enhancement, this means that the face

amount of the security is assigned to the 50

percent risk category.

(iii) Risk participations and syndications in

direct credit substitutes. (1) In the case of a

direct credit substitute in which a risk

participation 14 has been conveyed, the full

amount of the credit enhanced assets from

which risk of credit loss is directly or

indirectly retained or assumed, in whole or

in part, by the direct credit substitute is

converted to a credit equivalent amount at

100 percent. However, the pro rata share of

the credit equivalent amount that has been

conveyed through a risk participation is

assigned to whichever risk category is lower:

The risk category appropriate to the obligor,

after considering any relevant guarantees or

collateral, or the risk category appropriate to

the institution acquiring the participation.15

Any remainder of the credit equivalent

amount is assigned to the risk category

appropriate to the obligor, guarantor, or

collateral. For example, the pro rata share of

the full amount of the assets supported, in

whole or in part, by a direct credit substitute

conveyed as a risk participation to a U.S.

domestic depository institution or foreign

bank is assigned to the 20 percent risk

category. 16

(2) The capital treatment for risk

participations, either conveyed or acquired,

and syndications in direct credit substitutes

that are associated with an asset

securitization and are rated at least

investment grade is set forth in paragraph

B.5.(b)(ii) of this section. A lower risk

category may be applicable depending on the

obligor or nature of the institution acquiring

the participation.

(3) In the case of a direct credit substitute

in which a risk participation has been

acquired, the acquiring bank’s percentage

share of the direct credit substitute is

multiplied by the full amount of the credit

enhanced assets from which risk of credit

loss is directly or indirectly retained or

assumed, in whole or in part, by the direct

credit substitute and is converted to a credit

equivalent amount at 100 percent. The credit

equivalent amount of an acquisition of a risk

participation in a direct credit substitute is

assigned to the risk category appropriate to

the account party obligor or, if relevant, the

nature of the collateral or guarantees.

(4) In the case of a direct credit substitute

that takes the form of a syndication where

each bank is obligated only for its pro rata

share of the risk and there is no recourse to

the originating bank, each bank will only

include in its risk-based capital calculation

only its pro rata share of the credit enhanced

assets from which risk of credit loss is

directly or indirectly retained or assumed, in

whole or in part, by the direct credit

substitute. 17

(c) Limitations on risk-based capital

requirements. (i) Low-level recourse. If the

maximum contractual liability or exposure to

loss retained or assumed by a bank in

connection with a recourse
59972 Federal Register / Vol. 62, No. 214 / Wednesday, November 5, 1997 / Proposed Rules

18A privately-issued mortgage-backed security

may be treated as an indirect holding of the

underlying assets provided that: (1) The underlying

assets are held by an independent trustee and the

trustee has a first priority, perfected security

interest in the underlying assets on behalf of the

holders of the security; (2) either the holder of the

security has an undivided pro rata ownership

interest in the underlying mortgage assets or the

trust or single purpose entity (or conduit) that

issues the security has no liabilities unrelated to the

issued securities; (3) the security is structured such

that the cash flow from the underlying assets in all

cases fully meets the cash flow requirements of the

security without undue reliance on any

reinvestment income; and (4) there is no material

reinvestment risk associated with any funds

awaiting distribution to the holders of the security.

In addition, if the underlying assets of a mortgagebacked security are composed of more than one

type of asset, the entire mortgage-backed security is

generally assigned to the category appropriate to the

highest risk-weighted asset underlying the issue.

33The types of loans that qualify as loans secured

by multifamily residential properties are listed in

the instructions for preparation of the Consolidated

Reports of Condition and Income. In addition, from

the standpoint of the selling bank, when a

multifamily residential property loan is sold subject

to a pro rata loss sharing arrangement which

provides for the purchaser of the loan to share in

any loss incurred on the loan on a pro rata basis

with the selling bank, that portion of the loan is not

subject to the risk-based capital standards. In

connection with sales of multifamily residential

property loans in which the purchaser of the loan

shares in any loss incurred on the loan with the

selling institution on other than a pro rata basis, the

selling bank must treat these other loss sharing

arrangements in accordance with section II.B.5. of

this appendix A.

37Such assets include all nonlocal-currency

claims on, and the portions of claims that are

guaranteed by, non-OECD central governments and

those portions of local-currency claims on, or

guaranteed by, non-OECD central governments that

exceed the local-currency liabilities held by

subsidiary depository institutions.

38Customer liabilities on acceptances outstanding

involving nonstandard risk claims, such as claims

on U.S. depository institutions, are assigned to the

risk category appropriate to the identity of the

obligor or, if relevant, the nature of the collateral

or guarantees backing the claims. Portions of

acceptances conveyed as risk participations to U.S.

depository institutions or foreign banks are assigned

to the 20 percent risk category appropriate to shortterm claims guaranteed by U.S. depository

institutions and foreign banks.

obligation or a direct credit substitute is

less than the amount of capital which

would be held under the applicable

risk-based capital requirement for the

enhanced assets, the bank need only

hold capital equal to the maximum

contractual liability or exposure to loss,

less any recourse liability account

established in accordance with

generally accepted accounting

principles. This exception does not

apply to assets sold with implicit

recourse.

(ii) Mortgage-related securities or

participation certificates retained in a

mortgage loan swap. If a bank holds a

mortgage-related security or a participation

certificate as a result of a mortgage loan swap

with recourse, capital is required to support

the recourse obligation plus the percentage of

the mortgage-related security or participation

certificate that is not covered by the recourse

obligation. The total amount of capital

required for the on-balance sheet asset and

the recourse obligation, however, is limited

to the capital requirement for the underlying

loans, calculated as if the bank continued to

hold these loans as an on-balance sheet asset.

(iii) Related on-balance sheet assets. If a

recourse obligation or direct credit substitute

subject to section II.B.5. of this appendix A

also appears as an on-balance sheet asset, the

credit equivalent amount of the recourse

obligation or direct credit substitute is

determined in accordance with paragraph

B.5.(b) of this section and the balance sheet

asset is not separately included in a bank’s

risk-weighted assets, except in the case of

mortgage servicing assets and similar

arrangements with embedded recourse

obligations or direct credit substitutes. In

such cases, both the on-balance sheet assets

and the related recourse obligations and

direct credit substitutes are incorporated into

the risk-based capital calculation.

(d) Privately-issued mortgage-backed

securities. Generally, a privately-issued

mortgage-backed security meeting certain

criteria, set forth in the accompanying

footnote, 18 is essentially treated as an

indirect holding of the underlying assets, and

assigned to the same risk category as the

underlying assets, but in no case to the zero

percent risk category. However, any class of

a privately-issued mortgage-backed security

whose structure does not qualify it to be

regarded as an indirect holding of the

underlying assets or that can absorb more

than its pro rata share of loss without the

whole issue being in default (for example, a

so-called subordinated class) is treated in

accordance with paragraph B.5.(b) of this

section. Furthermore, all privately-issued

stripped mortgage-backed securities,

including interest-only strips (IOs), principalonly strips (POs), and similar instruments,

are assigned to the 100 percent risk weight

category, regardless of the issuer or

guarantor.

(e) Other stripped mortgage-backed

securities. All other stripped mortgagebacked securities, including interest-only

strips (IOs), principal-only strips (POs), and

similar instruments, are assigned to the 100

percent risk weight category, regardless of the

issuer or guarantor.

* * * * *

3. In appendix A to part 325, section

II.C., Category 1 through Category 3,

footnotes 15 through 32 are redesignated

as footnotes 19 through 36, the four

undesignated paragraphs under

Category 3—50 Percent Risk Weight are

designated as paragraphs a. through d.,

respectively, and newly redesignated

footnote 33 is revised to read as follows:

* * * * *

II. * * *

C. * * *

Category 3—50 Percent Risk Weight. * * *

b. * * * 33 * * *

* * * * *

4. In appendix A to part 325, section

II.C., Category 4—100 Percent Risk

Weight is revised to read as follows:

* * * * *

II. * * *

C. * * *

Category 4—100 Percent Risk Weight. a.

All assets not included in the categories

above are assigned to this category, which

comprises standard risk assets. The bulk of

the assets typically found in a loan portfolio

would be assigned to the 100 percent

category.

b. This category includes:

(1) Long-term claims on, and the portions

of long-term claims that are guaranteed by,

non-OECD banks, and all claims on nonOECD central governments that entail some

degree of transfer risk; 37

(2) All claims on foreign and domestic

private-sector obligors not included in the

categories above (including loans to

nondepository financial institutions and

bank holding companies);

(3) Claims on commercial firms owned by

the public sector;

(4) Customer liabilities to the bank on

acceptances outstanding involving standard

risk claims; 38

(5) Investments in fixed assets, premises,

and other real estate owned;

(6) Common and preferred stock of

corporations, including stock acquired for

debts previously contracted;

(7) Commercial and consumer loans

(except (a) those assigned to lower risk

categories due to recognized guarantees or

collateral and (b) loans secured by residential

property that qualify for a lower risk weight);

(8) All stripped mortgage-backed securities

and similar instruments;

(9) Industrial-development bonds and

similar obligations issued under the auspices

of state or political subdivisions of the OECDbased group of countries for the benefit of a

private party or enterprise where that party

or enterprise, not the government entity, is

obligated to pay the principal and interest;

and

(10) All obligations of states or political

subdivisions of countries that do not belong

to the OECD-based group of countries.

c. The following assets also are assigned a

risk weight of 100 percent if they have not

been deducted from capital: investments in

unconsolidated subsidiaries, joint ventures,

or associated companies; instruments that

qualify as capital issued by other banking

organizations; and servicing assets and

intangible assets.

* * * * *

5. In appendix A to part 325, section II.D.

is amended by redesignating footnotes 38

through 42 as footnotes 41 through 45 and by

revising the undesignated introductory
Federal Register / Vol. 62, No. 214 / Wednesday, November 5, 1997 / Proposed Rules 59973

39The sufficiency of collateral and guarantees for

off-balance-sheet items is determined by the market

value of the collateral of the amount of the

guarantee in relation to the face amount of the item,

except for derivative contracts, for which this

determination is generally made in relation to the

credit equivalent amount. Collateral and guarantees

are subject to the same provisions noted under

section II.B. of this appendix A.

40Forward forward deposits accepted are treated

as interest rate contracts.

paragraph of section II.D. and section

II.D.1. to read as follows:

* * * * *

II. * * *

D. * * *

The face amount of an off-balance sheet

item is generally incorporated into riskweighted assets in two steps. The face

amount is first multiplied by a credit

conversion factor, except for direct credit

substitutes and recourse obligations as

discussed in section II.D.1. of this appendix

A. The resultant credit equivalent amount is

assigned to the appropriate risk category

according to the obligor or, if relevant, the

guarantor or the nature of the collateral.39

1. Items With a 100 Percent Conversion

Factor. a. Except as otherwise provided in

section II.B.5. of this appendix A, the full

amount of an asset or transaction supported,

in whole or in part, by a direct credit

substitute or a recourse obligation. Direct

credit substitutes and recourse obligations

are defined in section II.B.5. of this appendix

A.

b. Sale and repurchase agreements, if not

already included on the balance sheet, and

forward agreements. Forward agreements are

legally binding contractual obligations to

purchase assets with drawdown which is

certain at a specified future date. These

obligations include forward purchases,

forward forward deposits placed, 40 and

partly-paid shares and securities, but they do

not include commitments to make residential

mortgage loans or forward foreign exchange

contracts.

c. Securities lent by a bank are treated in

one of two ways, depending on whether the

lender is exposed to risk of loss. If a bank,

as agent for a customer, lends the customer’s

securities and does not indemnify the

customer against loss, then the securities

lending transaction is excluded from the riskbased capital calculation. On the other hand,

if a bank lends its own securities or, acting

as agent for a customer, lends the customer’s

securities and indemnifies the customer

against loss, the transaction is converted at

100 percent and assigned to the risk weight

category appropriate to the obligor or, if

applicable, to any collateral delivered to the

lending bank or the independent custodian

acting on the lending bank’s behalf. When a

bank is acting as a customer’s agent in a

transaction involving the loan or sale of the

customer’s securities that is collateralized by

cash delivered to the lending bank, the

transaction is deemed to be collateralized by

cash on deposit with the bank for purposes

of determining the appropriate risk-weight

category, provided that any indemnification

is limited to no more than the difference

between the market value of the securities

lent or sold and the cash collateral received,

and any reinvestment risk associated with

the cash collateral is borne by the customer.

* * * * *

6. In appendix A to part 325, Table

II—Summary of Risk Weights and Risk

Categories is amended under Category

2—20 Percent Risk Weight by adding a

new paragraph (13) to read as follows:

* * * * *

Table II—Summary of Risk Weights and

Risk Categories

* * * * *

Category 2—20 Percent Risk Weight

* * * * *

(13) The face amount of a recourse

obligation, direct credit substitute, or assetor mortgage-backed security that is rated in

the highest investment grade category.

* * * * *

7. In appendix A to part 325, Table

II—Summary of Risk Weights and Risk

Categories is amended under Category

3—50 Percent Risk Weight by adding a

new paragraph (6) to read as follows:

* * * * *

Table II—Summary of Risk Weights and

Risk Categories

* * * * *

Category 3—50 Percent Risk Weight

* * * * *

[Option 2—Modified Gross-Up] (6) The full

amount of the credit enhanced assets from

which risk of credit loss is directly or

indirectly retained or assumed through a

recourse obligation, direct credit substitute,

or asset- or mortgage-backed security that is

rated investment grade (but below the highest

investment grade category).

* * * * *

8. In appendix A to part 325, Table

III—Credit Conversion Factors for OffBalance Sheet Items, the item ‘‘100

Percent Conversion Factor’’ is revised

and a new item ‘‘Credit Conversion for

Recourse Obligations and Direct Credit

Substitutes’’ is added after the item

‘‘Zero Percent Conversion Factor’’ to

read as follows:

* * * * *

Table III—Credit Conversion Factors for OffBalance Sheet Items 100 Percent Conversion

Factor

100 Percent Conversion Factor

(1) Sale and repurchase agreements, if not

already included on the balance sheet.

(2) Forward agreements representing

contractual obligations to purchase assets,

including financing facilities, with

drawdown certain at a specified future date.

(3) Securities lent, if the lending bank is

exposed to risk of loss.

* * * * *

Credit Conversion for Recourse Obligations

and Direct Credit Substitutes

The credit equivalent amount for an offbalance sheet recourse obligation or direct

credit substitute:

(1) That is not rated at least investment

grade is the full amount of the credit

enhanced assets from which risk of loss is

directly or indirectly retained or assumed,

subject to the low-level recourse rule.

(2) That is rated in the highest investment

grade category is its face amount.

(3) That is rated investment grade, but

below the highest investment grade category,

is [Option 1—Face Value Treatment] its face

amount.

[Option 2—Modified Gross-Up] the full

amount of the credit enhanced assets from

which risk of credit loss is directly or

indirectly retained or assumed.

* * * * *

Dated at Washington, D.C., this 16th day of

September, 1997. Federal Deposit Insurance

Corporation.

By order of the Board of Directors.

Robert E. Feldman,

Executive Secretary.

Office of Thrift Supervision

12 CFR CHAPTER V

Authority and Issuance

For the reasons set out in the

preamble, part 567 of chapter V of title

12 of the Code of Federal Regulations is

proposed to be amended as follows:

PART 567—CAPITAL

1. The authority citation for part 567

continues to read as follows:

Authority: 12 U.S.C. 1462, 1462a, 1463,

1464, 1467a, 1828(note).

2. Section 567.1 is amended by

removing and reserving paragraph (f), by

removing in paragraph (i)(2) including

text the phrase ‘‘§ 567.6(a)(vi)’’ and

adding in lieu thereof the phrase

‘‘§ 567.6(a)(1)(vi)’’ and by revising

paragraph (kk), to read as follows:

§ 567.1 Definitions.

* * * * *

(kk) Standby letter of credit. (1)

Financial guarantee-type standby letter

of credit means any letter of credit or

similar arrangement, however named or

described, that represents an irrevocable

obligation to the beneficiary on the part

of the issuer:

(i) To repay money borrowed by,

advanced to, or for the account of an

account party; or

(ii) To make payment on account of

any indebtedness undertaken by an

account party, in the event that the

account party fails to fulfill its

obligation to the beneficiary.

(2) Performance-based standby letter

of credit means any letter of credit, or

similar arrangement, however named or

described, which represents an

irrevocable obligation to the beneficiary

on the part of the issuer to make

payment on account of any default by a
59974 Federal Register / Vol. 62, No. 214 / Wednesday, November 5, 1997 / Proposed Rules

third party in the performance of a

nonfinancial or commercial obligation.

* * * * *

3. Section 567.6 is amended by

revising paragraphs (a) heading and

introductory text, (a)(1) introductory

text, and (a)(2) introductory text,

removing and reserving paragraphs

(a)(2)(i)(A) and (C), revising paragraphs

(a)(2)(i)(B) and (a)(3), and adding

paragraph (b) to read as follows:

§ 567.6 Risk-based capital credit riskweight categories.

(a) Risk-weighted assets. Riskweighted assets equal risk-weighted onbalance sheet assets (as computed under

paragraph (a)(1) of this section), plus

risk-weighted off-balance sheet items (as

computed under paragraph (a)(2) of this

section), plus risk-weighted recourse

obligations, direct credit substitutes,

and asset-and mortgage-backed

securities (as computed under

paragraph (a)(3) of this section). Assets

not included for purposes of calculating

capital pursuant to § 567.5 are not

included in calculating risk-weighted

assets.

(1) On-balance sheet assets. Except as

provided in paragraph (a)(3) of this

section, risk-weighted on-balance sheet

assets are computed by multiplying the

on-balance sheet asset amount times the

appropriate risk weight categories. The

risk weight categories for on-balance

sheet assets are:

* * * * *

(2) Off-balance sheet activities. Except

as provided in paragraph (a)(3) of this

section, risk-weights for off-balance

sheet items are determined by the

following two-step process. First, the

face amount of the off-balance sheet

item must be multiplied by the

appropriate credit conversion factor

listed in this paragraph (a)(2). This

calculation translates the face amount of

an off-balance sheet exposure into an

on-balance sheet credit-equivalent

amount. Second, the credit-equivalent

amount must be assigned to the

appropriate risk weight category using

the criteria regarding obligors,

guarantors, and collateral listed in

paragraph (a)(1) of this section, provided

that the maximum risk weight assigned

to the credit-equivalent amount of an

interest-rate or exchange-rate contract is

50 percent. The following are the credit

conversion factors and the off-balance

sheet items to which they apply:

(i) * * *

(B) Risk participations purchased in

bank acceptances;

* * * * *

(3) Recourse obligations, direct credit

substitutes, and asset- and mortgagebacked securities—(i) Risk-weighted

asset amount. Except as otherwise

provided in this paragraph (a)(3), to

calculate the risk-weighted asset amount

for a recourse obligation or a direct

credit substitute, multiply the amount of

assets from which risk of credit loss is

directly or indirectly retained or

assumed, by the appropriate risk weight

using the criteria regarding obligors,

guarantors, and collateral listed in

paragraph (a)(1) of this section. For

purposes of this paragraph (a)(3), the

amount of assets from which risk of

credit loss is directly or indirectly

retained or assumed means:

(A) For a financial guarantee-type

standby letter of credit, surety

arrangement, guarantee, or irrevocable

guarantee-type instrument, the amount

of assets that the direct credit substitute

fully or partially supports;

(B) For a subordinated interest or

security, the amount of the subordinated

interest or security, plus all more senior

interests or securities;

(C) For mortgage servicing rights that

are recourse obligations or direct credit

substitutes, the outstanding amount of

the loans serviced;

(D) For representations and warranties

(other than standard representations and

warranties), the amount of the assets

subject to the representations or

warranties;

(E) For loans on lines of credit that

provide credit enhancement for the

financial obligations of the financial

obligations of an account party, the

amount of the enhanced financial

obligations;

(F) For loans strips, the amount of the

loans; and

(G) For assets sold with recourse, the

amount of assets from which risk of

credit loss is directly or indirectly

retained, less any applicable recourse

liability account established in

accordance with generally accepted

accounting principles. Other types of

recourse obligations or direct credit

substitutes should be treated in

accordance with the principles

contained in this paragraph (a)(3)(i).

(ii) Investment grade recourse

obligations, direct credit substitutes,

and asset-and mortgage-backed

securities.—(A) Eligibility. A traded

position in an asset-or mortgage-backed

securitization is eligible for the

treatment described in this paragraph

(a)(3)(ii), if it has been rated investment

grade by a nationally recognized

statistical rating organization. A

recourse obligation or direct credit

substitute that is not a traded position

is eligible for the treatment described in

this paragraph (a)(3)(ii) if it has been

rated investment grade by two

nationally recognized statistical rating

organizations, the ratings are publicly

available, the ratings are based on the

same criteria used to rate securities sold

to the public, and the recourse

obligation or direct credit substitute

provide credit enhancement to a

securitization in which at least one

position is traded.

(B) Highest investment grade. To

calculate the risk-weighted asset amount

for a recourse obligation, direct credit

substitute, or asset-or mortgage-backed

security that is rated in the highest

investment grade category, multiply the

face amount of the position by a risk

weight of 20 percent.

(C) Other investment grade. [Option

I—Face Value Treatment] To calculate

the risk-weighted asset amount for a

recourse obligation, direct credit

substitute, or asset-or mortgage-backed

security that is rated investment grade,

multiply the face amount of the position

by a risk weight of 100 percent.

[Option II—Modified Gross-Up

Treatment] To calculate the riskweighted 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 (see paragraphs

(a)(3)(i)(A) through (F) of this section),

by a risk weight of 50 percent.

(iii) Participations. The risk-weighted

asset amount for a participation interest

in a recourse obligation or direct credit

substitute is calculated as follows:

(A) Determine the risk-weighted asset

amount for the recourse obligation or

direct credit substitute as if the savings

association held all of the interests in

the participation;

(B) Multiply this amount by the

percentage of the savings association’s

participation interest; and

(C) If the savings association is

exposed to more than its pro rata share

of the risk of credit loss on the recourse

obligation or direct credit substitute

(e.g., the savings association remains

secondarily liable on participations held

by others), add to the amount computed

under paragraph (a)(3)(iii)(B) of this

section, an amount computed as

follows: Multiply the amount of the

recourse obligation or direct credit

substitute by the percentage of the

recourse obligation or direct credit

substitute held by others and then

multiply the result by the lesser of the

risk weight appropriate for the holders

of those interests or the risk weight

appropriate to the recourse obligation or

direct credit substitute.

(iv) Alternative capital computation

for small business obligations.
Federal Register / Vol. 62, No. 214 / Wednesday, November 5, 1997 / Proposed Rules 59975

(A) Definitions. For the purposes of

this paragraph (a)(3)(iv):

(1) Qualified savings association

means a savings association that:

(i) Is well capitalized as defined in

§ 565.4 of this chapter without applying

the capital treatment described in

paragraph (a)(3)(iv)(B) of this section; or

(ii) Is adequately capitalized as

defined in § 565.4 of this chapter

without applying the capital treatment

described in paragraph (a)(3)(iv)(B) of

this section and has received written

permission from the OTS to apply that

capital calculation.

(2) Small business means a business

that meets the criteria for a small

business concern established by the

Small Business Administration in 12

CFR part 121 pursuant to 15 U.S.C. 632.

(B) Capital requirement. With respect

to a transfer of a small business loan or

lease of personal property with recourse

that is a sale under generally accepted

accounting principles, a qualified

savings association may elect to include

only the amount of its retained recourse

in its risk-weighted assets for the

purposes of this paragraph (a)(3). To

qualify for this election, the savings

association must establish and maintain

a reserve under generally accepted

accounting principles sufficient to meet

the reasonable estimated liability of the

savings association under the recourse

obligation.

(C) Aggregate amount of recourse. The

total outstanding amount of recourse

retained by a qualified savings

association with respect to transfers of

small business loans and leases of

personal property and included in the

risk-weighted assets of the savings

association as described in this

paragraph (a)(3), may not exceed 15

percent of the association’s total capital

computed under § 567.5(c)(4).

(D) Savings association that ceases to

be a qualified savings association or

that exceeds aggregate limits. If a

savings association ceases to be a

qualified savings association or exceeds

the aggregate limit described in

paragraph (a)(3)(iv)(C) of this section,

the savings association may continue to

apply the capital treatment described in

paragraph (a)(3)(iv)(B) of this section to

transfers of small business loans and

leases of personal property that

occurred when the association was a

qualified savings association and did

not exceed the limit.

(E) Prompt corrective action not

affected. (1) A savings association shall

compute its capital without regard to

this paragraph (a)(3)(iv) of this section

for purposes of prompt corrective action

(12 U.S.C. 1831o), unless the savings

association is adequately or well

capitalized without applying the capital

treatment described in this paragraph

(a)(3)(iv) and would be well capitalized

after applying that capital treatment.

(2) A savings association shall

compute its capital requirement without

regard to this paragraph (a)(3)(iv) for the

purposes of applying 12 U.S.C.

1381o(g), regardless of the association’s

capital level.

(v) Limitations on risk-based capital

requirements.—(A) Low level recourse.

(1) If the maximum contractual liability

or exposure to credit loss retained or

assumed by a savings association in

connection with a recourse obligation or

a direct credit substitute is less than the

effective risk-based capital requirement

for the enhanced asset, the risk based

capital requirement is limited to the

maximum contractual liability or

exposure to credit loss. For assets sold

with recourse, the amount of capital

required to support the recourse

obligation is limited to the maximum

contractual liability or exposure to

credit loss less the amount of the

recourse liability account established in

accordance with generally accepted

accounting principles.

(2) The low level recourse limitation

does not apply to assets sold with

implicit recourse.

(B) Mortgage-related securities or

participation certificates retained in a

mortgage loan swap. If a savings

association holds a mortgage-related

security or a participation certificate as

a result of a mortgage loan swap with

recourse, capital is required to support

the recourse obligation (including

consideration of any low level recourse

limitation described at paragraph

(a)(3)(v)(A) of this section), plus the

percentage of the 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 onbalance sheet asset and the recourse

obligation, however, is limited to the

capital requirement for the underlying

loans, calculated as if the savings

association continued to hold these

loans as an on-balance sheet asset.

(C) Related on-balance sheet assets.

To the extent that an asset is included

in the calculation of the risk-based

capital requirement under this

paragraph (a)(3), and may also be

included as an on-balance sheet asset

under paragraph (a)(1) of this section,

the asset shall be risk-weighted only

under this paragraph (a)(3) except:

(1) Mortgage servicing assets and

similar arrangements with embedded

recourse obligations or direct credit

substitutes are risk weighted as onbalance sheet assets under paragraph

(a)(1) of this section, and the related

recourse obligations and direct credit

substitutes are risk-weighted under this

paragraph (a)(3); and

(2) Purchased subordinated interests

that are high quality mortgage-related

securities are not subject to risk

weighting under this paragraph (a)(3).

Rather, the face values of these assets

are risk-weighted as on-balance sheet

assets under paragraph (a)(1)(ii)(H) of

this section.

(vi) Obligations of subsidiaries. If a

savings association retains a recourse

obligation or assumes a direct credit

substitute on the obligation of a

subsidiary that is not an includable

subsidiary, and the recourse obligation

or direct credit substitute is an equity or

debt investment in that subsidiary

under generally accepted accounting

principles, the face amount of the

recourse obligation or direct credit

substitute is deducted for capital under

§§ 567.5(a)(2) and 567.9(c). All other

recourse obligations and direct credit

substitutes retained or assumed by a

savings association on the obligations of

an entity in which the savings

association has an equity investment are

risk-weighted in accordance with

paragraphs (a)(3)(i) through (v) of this

section.

(b) Definitions. For the purposes of

this section:

(1) Direct credit substitute means an

arrangement in which a savings

association assumes, in form or in

substance, any risk of credit loss

directly or indirectly associated with a

third party asset or other financial

claim, that exceeds the savings

association’s pro rata share of the asset

or claim. If a savings association has no

claim on an asset, then the assumption

of any risk of credit loss is a direct

credit substitute. Direct credit

substitutes include, but are not limited

to:

(i) Financial guarantee-type standby

letters of credit that support financial

claims on the account party;

(ii) Guarantees, surety arrangements,

and irrevocable guarantee-type

instruments backing financial claims;

(iii) Purchased subordinated interests

or securities that absorb more than their

pro rata share of losses from the

underlying assets;

(iv) Loans or lines of credit that

provide credit enhancement for the

financial obligations of an account

party; and

(v) Purchased loan servicing assets if

the servicer is responsible for credit

losses associated with the loans being

serviced (other than a servicer cash

advance as defined in this section), or

if the servicer makes or assumes
59976 Federal Register / Vol. 62, No. 214 / Wednesday, November 5, 1997 / Proposed Rules

representations and warranties on the

loans other than standard representation

and warranties as defined in this

section.

(2) Rated means, with respect to an

instrument or obligation, that the

instrument or obligation has received a

credit rating from a nationallyrecognized statistical rating

organization. An instrument or

obligation is rated investment grade if it

has received a credit rating that falls

within one of the four highest rating

categories used by the organization. An

instrument or obligation is rated in the

highest investment grade if it has

received a credit rating that falls within

the highest rating category used by the

organization.

(3) Recourse means the retention, in

form or in substance, of any risk of

credit loss directly or indirectly

associated with a transferred asset, that

exceeds a pro rata share of the savings

association’s claim on the asset. If a

savings association has no claim on a

transferred asset, then the retention of

any risk of credit loss is recourse. A

recourse obligation typically arises

when an institution transfers its assets

and retains an obligation to repurchase

the assets, or to absorb losses due to a

default of principal or interest or any

other deficiency in the performance of

the underlying obligor or some other

party. Recourse may exist implicitly

where a savings association provides

credit enhancement beyond any

contractual obligation to support the

assets it has sold. Recourse obligations

include, but are not limited to:

(i) Representations and warranties on

the transferred assets other than

standard representations and warranties

as defined in this section;

(ii) Retained loan servicing assets if

the servicer is responsible for losses

associated with the loans serviced (other

than a servicer cash advance as defined

in this section);

(iii) Retained subordinated interests

or securities that absorb more than their

pro rata share of losses from the

underlying assets;

(iv) Assets sold under an agreement to

repurchase; and

(v) Loan strips sold without direct

recourse where the maturity of the

transferred loan is shorter than the

maturity of the commitment.

(4) Servicer cash advance means

funds that a residential mortgage loan

servicer advances to ensure an

uninterrupted flow of payments or the

timely collection of residential mortgage

loans, including disbursements made to

cover foreclosure costs or other

expenses arising from a mortgage loan to

facilitate its timely collection. A servicer

cash advance is not a recourse

obligation or a direct credit substitute if:

(i) The mortgage servicer is entitled to

full reimbursement; or

(ii) For any one residential mortgage

loan, nonreimbursed advances are

contractually limited to an insignificant

amount of the outstanding principal on

that loan.

(5) Standard representations and

warranties mean contractual provisions

that a savings association extends when

it transfers assets (including loan

servicing assets) or assumes when it

purchases loan servicing assets. To

qualify as a standard representation or

warranty, a contractual provision must:

(i) Refer to facts that the seller or

servicer can verify, and has verified

with reasonable due diligence, prior to

the time that assets are transferred (or

servicing assets are acquired);

(ii) Refer to a condition that is within

the control of the seller or servicer; or

(iii) Provide for the return of assets in

the event of fraud or documentation

deficiencies.

(6) Traded position means a recourse

obligation, direct credit substitute, or

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:

(i) The position would be sold to

investors relying on the rating; or

(ii) A third party would, in reliance

on the rating, enter into a transaction

such as a loan or repurchase agreement

involving the position.

Dated: September 3, 1997.

By the Office of Thrift Supervision.

Nicolas P. Retsinas,

Director.

[FR Doc. 97–28828 Filed 11–4–97; 8:45 am]

BILLING CODES: 4810–33–P, 6210–01–P, 6714–01–P,

6720–01–P