[Federal Register Volume 62, Number 214 (Wednesday, November 5, 1997)]
[Proposed Rules]
[Pages 59944-59976]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 97-28828]



[[Page 59943]]

_______________________________________________________________________

Part II

Department of the Treasury
Office of the Comptroller of the Currency



12 CFR Part 3

Federal Reserve System



12 CFR Parts 208 and 225

Federal Deposit Insurance Corporation



12 CFR Part 325

Department of the Treasury
Office of Thrift Supervision



12 CFR Part 567



_______________________________________________________________________



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

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

[[Page 59944]]



DEPARTMENT OF THE TREASURY

Office of the Comptroller of the Currency

12 CFR Part 3

[Docket No. 97-22]
RIN 1557-AB14

FEDERAL RESERVE SYSTEM

12 CFR Parts 208 and 225

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

FEDERAL DEPOSIT INSURANCE CORPORATION

12 CFR Part 325

RIN 3064-AB31

DEPARTMENT OF THE TREASURY

Office of Thrift Supervision

12 CFR Part 567

[Docket No. 97-86]
RIN 1550-AB11


Risk-Based Capital Standards; Recourse and Direct Credit 
Substitutes

AGENCIES: Office of the Comptroller of the Currency, Treasury; Board of 
Governors of the Federal Reserve System; Federal Deposit Insurance 
Corporation; and Office of Thrift Supervision, Treasury.

ACTION: Joint notice of proposed rulemaking.

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SUMMARY: The Office of the Comptroller of the Currency (OCC), Board of 
Governors of the Federal Reserve System (Board), Federal Deposit 
Insurance Corporation (FDIC), and Office of Thrift Supervision (OTS), 
(collectively, the agencies) are proposing revisions to their risk-
based capital standards to address the regulatory capital treatment of 
recourse obligations and direct credit substitutes that expose banks, 
bank holding companies, and thrifts (collectively, banking 
organizations) to credit risk. The proposal would treat direct credit 
substitutes and recourse obligations consistently and would use credit 
ratings and possibly certain other alternative approaches to match the 
risk-based capital assessment more closely to a banking organization's 
relative risk of loss in asset securitizations.
    The agencies intend that any final rules adopted in connection with 
this proposal that result in increased risk-based capital requirements 
for banking organizations apply only to transactions consummated after 
the effective date of the final rules.

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

ADDRESSES: Comments should be directed to:
    OCC: Written comments may be submitted electronically to 
<a href="/cdn-cgi/l/email-protection#98eafdffebb6fbf7f5f5fdf6ecebd8f7fbfbb6eceafdf9ebb6fff7ee"><span class="__cf_email__" data-cfemail="aedccbc9dd80cdc1c3c3cbc0daddeec1cdcd80dadccbcfdd80c9c1d8">[email protected]</span></a> or by mail to Docket No. 97-22, 
Communications Division, Third Floor, Office of the Comptroller of the 
Currency, 250 E Street, SW., Washington, DC 20219. Comments will be 
available for inspection and photocopying at that address.
    Board: Comments, which should refer to Docket No. R-0985, may be 
mailed to the Board of Governors of the Federal Reserve System, 20th 
Street and Constitution Avenue, NW., Washington, DC 20551, to the 
attention of Mr. William Wiles, Secretary. Comments addressed to the 
attention of Mr. Wiles may be delivered to the Board's mail room 
between 8:45 a.m. and 5:15 p.m., and to the security control room 
outside of those hours. Both the mail room and the security control 
room are accessible from the courtyard entrance on 20th Street between 
Constitution Avenue and C Street, NW. Comments may be inspected in Room 
MP500 between 9 a.m. and 5 p.m. weekdays, except as provided in 
Sec. 261.8 of the FRB's Rules Regarding Availability of Information, 12 
CFR 261.8.
    FDIC: Written comments should be addressed to Robert E. Feldman, 
Executive Secretary, Attention: Comments/OES, Federal Deposit Insurance 
Corporation, 550 17th Street, N.W., Washington, D.C. 20429. Comments 
may be hand delivered to the guard station at the rear of the 550 17th 
Street Building (located on F Street), on business days between 7:00 
a.m. and 5:00 p.m. (Fax number: (202) 898-3838; Internet address: 
<a href="/cdn-cgi/l/email-protection#593a3634343c372d2a193f3d303a773e362f"><span class="__cf_email__" data-cfemail="eb888486868e859f98ab8d8f8288c58c849d">[email protected]</span></a>). 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: 
<a href="/cdn-cgi/l/email-protection#7b0b0e191712185512151d143b140f08550f091e1a08551c140d"><span class="__cf_email__" data-cfemail="dbabaeb9b7b2b8f5b2b5bdb49bb4afa8f5afa9bebaa8f5bcb4ad">[email protected]</span></a>. Those commenting by e-mail should include 
their name and telephone number. Comments will be available for 
inspection at 1700 G Street, N.W., from 9:00 to 4:00 p.m. on business 
days.

FOR FURTHER INFORMATION CONTACT: OCC: David Thede, Senior Attorney, 
Securities and Corporate Practices Division (202/874-5210); Dennis 
Glennon, Financial Economist, Risk Analysis Division (202/874-5700); or 
Steve Jackson, National Bank Examiner, Treasury and Market Risk (202/
874-5070).
    Board: Thomas R. Boemio, Senior Supervisory Financial Analyst (202/
452-2982); or Norah Barger, Assistant Director (202/452-2402), Division 
of Banking Supervision and Regulation. For the hearing impaired only, 
Telecommunication Device for the Deaf (TDD), Diane Jenkins (202/452-
3544), Board of Governors of the Federal Reserve System, 20th and C 
Streets, NW, Washington, DC 20551.
    FDIC: Robert F. Storch, Chief, Accounting Section, Division of 
Supervision, (202/898-8906), or Jamey G. Basham, Counsel, Legal 
Division (202/898-7265).
    OTS: John F. Connolly, Senior Program Manager for Capital Policy 
(202/906-6465), Supervision Policy; Michael D. Solomon, Senior Policy 
Advisor (202/906-5654), Supervision Policy; Fred Phillips-Patrick, 
Senior Financial Economist (202/906-7295), Research and Analysis; 
Robert Kazdin, Senior Project Manager (202/906-5759), Research and 
Analysis; Karen Osterloh, Assistant Chief Counsel (202/906-6639), 
Regulation and Legislation Division, Office of Thrift Supervision, 1700 
G Street, N.W., Washington, D.C. 20552.

SUPPLEMENTARY INFORMATION:

Table of Contents

I. Introduction and Background
    A. Overview
    B. Purpose and Effect
    C. Background
    1. Recourse and Direct Credit Substitutes
    2. Prior History
    D. Current Risk-based Capital Treatment of Recourse and Direct 
Credit Substitutes
    1. Recourse
    2. Direct Credit Substitutes
    3. Problems with Existing Risk-based Capital Treatments of 
Recourse Arrangements and Direct Credit Substitutes
    E. GAAP Accounting Treatment of Recourse Arrangements
II. Notice of Proposed Rulemaking
    A. Definitions
    1. Recourse
    2. Direct Credit Substitute
    3. Risks Other than Credit Risks
    4. Implicit Recourse
    5. Subordinated Interests in Loans or Pools of Loans

[[Page 59945]]

    6. Second Mortgages
    7. Representations and Warranties
    8. Loan Servicing Arrangements
    9. Spread Accounts and Overcollateralization
    B. Treatment of Direct Credit Substitutes
    C. Multi-level Ratings-based Approach
    1. 1994 Notice
    2. Effect of Ratings Downgrades
    3. Non-traded Positions
    D. Face Value and Modified Gross-up Alternatives for Investment 
Grade Positions Below the Highest Investment Grade Rating
    1. Description of Approaches
    2. Examples of Face Value and Modified Gross-up Approaches
    E. Alternative Approaches
    1. Ratings Benchmark Approach
    2. Internal Information Approaches
    a. Historical Loss Approach
    b. Bank Model Approach
III. Regulatory Flexibility Act
IV. Paperwork Reduction Act
V. Executive Order 12866
VI. OCC and OTS--Unfunded Mandates Reform Act of 1995

I. Introduction and Background

A. Overview

    The agencies are proposing to amend their risk-based capital 
standards to clarify and change the treatment of certain recourse 
obligations, direct credit substitutes, and securitized transactions 
that expose banking organizations to credit risk.
    This proposal would amend the agencies' risk-based capital 
standards to:
    <bullet> Define ``recourse'' and revise the definition of ``direct 
credit substitute''; <SUP>1</SUP>
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    \1\ The OTS is adding a definition of ``standby-type letter of 
credit'' to be consistent with the other agencies.
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    <bullet> Treat recourse obligations and direct credit substitutes 
consistently for risk-based capital purposes; and
    <bullet> Vary the capital requirements for traded and non-traded 
<SUP>2</SUP> positions in securitized transactions according to their 
relative risk exposure, using credit ratings from nationally-recognized 
statistical rating organizations <SUP>3</SUP> (rating agencies) to 
measure the level of risk.
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    \2\ See section II.C.3 of this preamble for a discussion of the 
distinction between ``traded'' and ``non-traded'' positions.
    \3\ ``Nationally recognized statistical rating organization'' 
means an entity recognized by the Division of Market Regulation of 
the Securities and Exchange Commission as a nationally recognized 
statistical rating organization for various purposes, including the 
capital rules for broker-dealers. See SEC Rule 15c3-1(c)(2)(vi)(E), 
(F) and (H) (17 CFR 240.15c3-1(c)(2)(vi)(E), (F), and (H).
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    Additionally, this proposal discusses and requests comment on two 
possible alternatives to the use of credit ratings for non-traded 
positions in securitized transactions, either or both of which may be 
adopted, in whole or in part, in the final rule. These alternatives 
would:
    <bullet> Use criteria developed by the agencies, based on the 
criteria of the rating agencies, to determine the capital requirements; 
or
    <bullet> Permit institutions to use historical loss information to 
determine the capital requirement for direct credit substitutes and 
recourse obligations.
    The agencies request comment on all aspects of this proposal.

B. Purpose and Effect

    Implementation of all aspects of this proposal would result in more 
consistent treatment of recourse obligations and similar transactions 
among the agencies, more consistent risk-based capital treatment for 
transactions involving similar risk, and capital requirements that more 
closely reflect a banking organization's relative exposure to credit 
risk.
    The agencies intend that any final rules adopted in connection with 
this proposal that result in increased risk-based capital requirements 
for banking organizations apply only to transactions that are 
consummated after the effective date of those final rules. The agencies 
intend that any final rules adopted in connection with this proposal 
that result in reduced risk-based capital requirements for banking 
organizations apply to all transactions outstanding as of the effective 
date of those final rules and to all subsequent transactions. Because 
some ongoing securitization conduits may need additional time to adapt 
to any new capital treatments, the agencies intend to permit asset 
securitizations with no fixed term, e.g., asset-backed commercial paper 
conduits, to apply the existing capital rules for up to two years after 
the effective date of any final rule.

C. Background

1. Recourse and Direct Credit Substitutes
    Asset securitization is the process by which loans and other 
receivables are pooled, reconstituted into one or more classes or 
positions, and then sold. Securitization provides an efficient 
mechanism for institutions to buy and sell loan assets and thereby to 
make them more liquid.
    Securitizations typically carve up the risk of credit losses from 
the underlying assets and distribute it to different parties. The 
``first dollar'' loss or subordinate position is first to absorb credit 
losses; the ``senior'' investor position is last; and there may be one 
or more loss positions in between (``second dollar'' loss positions). 
Each loss position functions as a credit enhancement for the more 
senior loss positions in the structure.
    For residential mortgages sold through certain Federally-sponsored 
mortgage programs, a Federal government agency or Federally-sponsored 
agency guarantees the securities sold to investors. However, many of 
today's asset securitization programs involve nonmortgage assets or are 
not supported in any way by the Federal government or a Federally-
sponsored agency. Sellers of these privately securitized assets 
therefore often provide other forms of credit enhancement--first and 
second dollar loss positions--to reduce investors' risk of credit loss.
    Sellers may provide this credit enhancement themselves through 
recourse arrangements. For purposes of this proposal, ``recourse'' 
refers to any risk of credit loss that an institution retains in 
connection with the transfer of its assets. While banking organizations 
have long provided recourse in connection with sales of whole loans or 
loan participations, recourse arrangements today are frequently 
associated with asset securitization programs.
    Sellers may also arrange for a third party to provide credit 
enhancement in an asset securitization. If the third-party enhancement 
is provided by another banking organization, that organization assumes 
some portion of the assets' credit risk. For purposes of this proposal, 
all forms of third-party enhancements, i.e., all arrangements in which 
an institution assumes risk of credit loss from third-party assets or 
other claims that it has not transferred, are referred to as ``direct 
credit substitutes.'' <SUP>4</SUP> The economic substance of an 
institution's risk of credit loss from providing a direct credit 
substitute can be identical to its risk of credit loss from 
transferring an asset with recourse.
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    \4\ As used in this proposal, the terms ``credit enhancement'' 
and ``enhancement'' refer to both recourse arrangements and direct 
credit substitutes.
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    Depending on the type of securitization transaction, a portion of 
the total credit enhancement may also be provided internally, as part 
of the securitization structure, through the use of spread accounts, 
overcollaterali-
zation, or other forms of self-enhancement. Many asset securitizations 
use a combination of internal enhancement, recourse, and third-party 
enhancement to protect investors from risk of credit loss.
2. Prior History
    On June 29, 1990, the Federal Financial Institutions Examination 
Council (FFIEC) published a request for comment on recourse 
arrangements. See

[[Page 59946]]

55 FR 26766 (June 29, 1990). The publication announced the agencies' 
intent to review the regulatory capital, reporting, and lending limit 
treatment of assets transferred with recourse and similar transactions, 
and set out a broad range of issues for public comment. The FFIEC 
received approximately 150 comment letters. The FFIEC then narrowed the 
scope of the review to the reporting and capital treatment of recourse 
arrangements and direct credit substitutes that expose banking 
organizations to credit-related risks. The OTS implemented some of the 
FFIEC's proposals (including the definition of recourse) on July 29, 
1992 (57 FR 33432).
    In July 1992, after receiving preliminary recommendations from an 
interagency staff working group, the FFIEC directed the working group 
to carry out a study of the likely impact of those recommendations on 
banking organizations, financial markets, and other affected parties. 
As part of that study, the working group held a series of meetings with 
representatives from 13 organizations active in the securitization and 
credit enhancement markets. Summaries of the information provided to 
the working group and a copy of the working group's letter sent to 
participants prior to the meetings are in the FFIEC's public file on 
recourse arrangements and are available for public inspection and 
photocopying. Additional material provided to the agencies from 
financial institutions and others since these meetings has also been 
placed in the FFIEC's public file. The FFIEC's offices are located at 
2100 Pennsylvania Avenue, NW., Suite 200, Washington, DC 20037.
    On May 25, 1994, the agencies published a Federal Register notice 
(1994 Notice) containing a proposal to reduce the capital requirement 
for banks for low-level recourse transactions (transactions in which 
the capital requirement would otherwise exceed an institution's maximum 
contractual exposure); to treat first-loss (but not second-loss) direct 
credit substitutes like recourse; and to implement definitions of 
``recourse,'' ``direct credit substitute,'' and related terms. 59 FR 
27116 (May 25, 1994). The 1994 Notice also contained, in an advance 
notice of proposed rulemaking, a proposal to use credit ratings to 
determine the capital treatment of certain recourse obligations and 
direct credit substitutes. The OCC, Board, and FDIC (the Banking 
Agencies) have since implemented the capital reduction for low-level 
recourse transactions required by section 350 of the Riegle Community 
Development and Regulatory Improvement Act, Public Law 103-325, 12 
U.S.C. 4808. 60 FR 17986 (OCC, April 10, 1995), 60 FR 8177 (Board, 
February 13, 1995); 60 FR 15858 (FDIC, March 28, 1995). (The OTS risk-
based capital regulation already included the low-level recourse 
treatment required by 12 U.S.C. 4808. See 60 FR 45618, August 31, 
1995.) The other portions of the 1994 Notice will be addressed in this 
proposal.
    The agencies have also implemented section 208 of the Riegle 
Community Development and Regulatory Improvement Act of 1994, Public 
Law 103-325, 108 Stat. 2160, 12 U.S.C. 1835, which made available an 
alternative risk-based capital treatment for qualifying transfers of 
small business obligations with recourse. 60 FR 45611(Board final rule, 
August 31, 1995); 60 FR 45605 (FDIC interim rule, August 31, 1995); 60 
FR 45617 (OTS interim rule, August 31, 1995); 60 FR 47455 (OCC interim 
rule, September 13, 1995).

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

    Currently, the agencies' risk-based capital standards apply 
different treatments to recourse arrangements and direct credit 
substitutes. As a result, capital requirements applicable to credit 
enhancements do not consistently reflect credit risk. The Banking 
Agencies' current rules are also not entirely consistent with those of 
the OTS.
1. Recourse
    The agencies' risk-based capital guidelines prescribe a single 
treatment for assets transferred with recourse regardless of whether 
the transaction is reported as a financing or a sale of assets in a 
bank's Consolidated Reports of Condition and Income (Call Report). 
Assets transferred with any amount of recourse in a transaction 
reported as a financing remain on the balance sheet. Assets transferred 
with recourse in a transaction that is reported as a sale create off-
balance sheet exposures. The entire outstanding amount of the assets 
sold (not just the amount of the recourse) is converted into an on-
balance sheet credit equivalent amount using a 100% credit conversion 
factor, and this credit equivalent amount is risk-weighted. 
<SUP>5</SUP> In either case, risk-based capital is held against the 
full, risk-weighted amount of the transferred assets, subject to the 
low-level recourse rule which limits the maximum risk-based capital 
requirement to the bank's maximum contractual obligation.
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    \5\ Current rules also provide for special treatment of sales of 
small business loan obligations with recourse. See 12 U.S.C. 1835.
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    For leverage capital ratio purposes, if a sale with recourse is 
reported as a financing, then the assets sold with recourse remain on 
the selling bank's balance sheet. If a sale with recourse is reported 
as a sale, the assets sold do not remain on the selling bank's balance 
sheet.
2. Direct Credit Substitutes
    a. Banking Agencies. Direct credit substitutes are treated 
differently from recourse under the current risk-based capital 
standards. Under the Banking Agencies' standards, off-balance sheet 
direct credit substitutes, such as financial standby letters of credit 
provided for third-party assets, carry a 100% credit conversion factor. 
However, only the dollar amount of the direct credit substitute is 
converted into an on-balance sheet credit equivalent so that capital is 
held only against the face amount of the direct credit substitute. The 
capital requirement for a recourse arrangement, in contrast, is 
generally based on the full amount of the assets enhanced.
    If a direct credit substitute covers less than 100% of the 
potential losses on the assets enhanced, the current capital treatment 
results in a lower capital charge for a direct credit substitute than 
for a comparable recourse arrangement. For example, if a direct credit 
substitute covers losses up to the first 20% of the assets enhanced, 
then the on-balance sheet credit equivalent amount equals that 20% 
amount and risk-based capital is held against only the 20% amount. In 
contrast, required capital for a first-loss 20% recourse arrangement is 
higher because capital is held against the full outstanding amount of 
the assets enhanced.
    Banking organizations are taking advantage of this anomaly, for 
example, by providing first loss letters of credit to asset-backed 
commercial paper conduits that lend directly to corporate customers. 
This results in a significantly lower capital requirement than if the 
loans were on the banking organizations' balance sheets.
    Under the proposal, the definition of direct credit substitute is 
expanded to include some items that already are partially reflected on 
the balance sheet, such as purchased subordinated interests. Currently, 
under the Banking Agencies' guidelines, these interests receive the 
same capital treatment as off-balance sheet direct credit substitutes. 
Purchased subordinated interests are placed in the appropriate risk-
weight category. In contrast, if a banking organization retains a

[[Page 59947]]

subordinated interest in connection with the transfer of its own 
assets, this is considered recourse. As a result, the institution must 
hold capital against the carrying amount of the retained subordinated 
interest as well as the outstanding amount of all senior interests that 
it supports.
    b. OTS. The OTS risk-based capital regulation treats some forms of 
direct credit substitutes (e.g., financial standby letters of credit) 
in the same manner as the Banking Agencies' guidelines. However, unlike 
the Banking Agencies, the OTS treats purchased subordinated interests 
under its general recourse provisions (except for certain high quality 
subordinated mortgage-related securities). The risk-based capital 
requirement is based on the carrying amount of the subordinated 
interest plus all senior interests, as though the thrift owned the full 
outstanding amount of the assets enhanced.
3. Problems With Existing Risk-based Capital Treatments of Recourse 
Arrangements and Direct Credit Substitutes.
    The agencies are proposing changes to the risk-based capital 
standards to address the following major concerns with the current 
treatments of recourse and direct credit substitutes:
    <bullet> 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.
    <bullet> The capital treatment does not recognize differences in 
risk associated with different loss positions in asset securitizations.
    <bullet> 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,<SUP>6</SUP> the 
agencies continue to require risk-based capital in addition to the GAAP 
recourse liability account for recourse obligations.
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    \6\ The OTS has followed GAAP since 1989 for reporting purposes 
and for computation of the capital leverage ratio.
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    The agencies have considered the arguments that several commenters 
(responding to the 1994 Notice) made for adopting for regulatory 
capital purposes the GAAP treatment for all assets sold with recourse, 
including those sold with low levels of recourse. Under such a 
treatment, assets sold with recourse in accordance with GAAP would have 
no capital requirement, but the GAAP recourse liability account would 
provide some level of protection against losses.
    One of the principal purposes of regulatory capital is to provide a 
cushion against unexpected losses. In contrast, the GAAP recourse 
liability account is, in effect, a specific reserve that primarily 
takes into account the probable expected losses under the recourse 
provision. The capital guidelines explicitly state that specific 
reserves may not be included in regulatory capital.
    Even though a transferring institution may reduce its exposure to 
potential catastrophic losses by limiting the amount of recourse it 
provides, it may still retain, in many cases, the bulk of the credit 
risk inherent in the assets. For example, an institution transferring 
high quality assets with a reasonably estimated expected loss rate of 
one percent that retains ten percent recourse in the normal course of 
business will sustain the same amount of losses it would have had the 
assets not been transferred. This occurs because the amount of exposure 
under the recourse provision is very high relative to the amount of 
expected losses. In such transactions the transferor has not 
significantly reduced its risk for purposes of assessing regulatory 
capital and should continue to be assessed regulatory capital as though 
the assets had not been transferred.
    Further, the agencies are concerned that an institution 
transferring assets with recourse might significantly underestimate its 
losses under the recourse provision or the fair value of its recourse 
obligation, in which case it would not establish an appropriate GAAP 
recourse liability account for the exposure. If the transferor recorded 
an inappropriately small liability in the GAAP recourse liability 
account for a succession of asset transfers, it could accumulate large 
amounts of credit risk that would be only partially reflected on the 
balance sheet.
    For these reasons, the agencies have not proposed to adopt for 
regulatory capital purposes the GAAP treatment for assets sold with 
recourse. The agencies invite additional comments on this issue.

II. Notice of Proposed Rulemaking

    This proposal would amend the agencies' risk-based capital 
standards as follows:
    <bullet> Define recourse and revise the definition of direct credit 
substitute (See section II.A of this preamble);
    <bullet> Treat recourse obligations and direct credit substitutes 
consistently for risk-based capital purposes (See section II.B of this 
preamble); and
    <bullet> 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:
    <bullet> Use criteria developed by the agencies, based on the 
criteria of the rating agencies, to determine the capital requirements; 
or
    <bullet> 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.<SUP>7</SUP>
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    \7\ The OTS currently defines the term ``recourse'' more broadly 
than the proposal to include arrangements involving credit risk that 
a thrift assumes or accepts from third-party assets as well as risk 
that it retains in an asset transfer. Under the proposal, as 
explained below, credit risk that an institution assumes from third-
party assets would fall under the definition of ``direct credit 
substitute'' rather than ``recourse.''

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[[Page 59948]]

    Currently, the term ``recourse'' is not explicitly defined in the 
Banking Agencies' risk-based capital guidelines. Instead, the 
guidelines use the term ``sale of assets with recourse,'' which is 
defined by reference to the Call Report Instructions. See Call Report 
Instructions, Glossary (entry for ``Sales of Assets''). Once a 
definition of recourse is adopted in the risk-based capital guidelines, 
the Banking Agencies would remove the cross-reference to the Call 
Report instructions from the guidelines. The OTS capital regulation 
currently provides a definition of the term ``recourse,'' which would 
also be replaced once a final definition of recourse is adopted.
2. Direct Credit Substitute
    The proposed definition of ``direct credit substitute'' is intended 
to mirror the definition of recourse. The term ``direct credit 
substitute'' would refer to any arrangement in which an institution 
assumes risk of credit-related losses from assets or other claims it 
has not transferred, if the risk of credit loss exceeds the 
institution's pro rata share of the assets or other claims. Currently, 
under the Banking Agencies' guidelines, this term covers guarantees and 
guarantee-type arrangements. As revised, it would also explicitly 
include items such as purchased subordinated interests, agreements to 
cover credit losses that arise from purchased loan servicing rights, 
and subordinated extensions of credit that provide credit enhancement.
3. Risks Other than Credit Risks
    A capital charge would be assessed only against arrangements that 
create exposure to credit or credit-related risks. This continues the 
agencies' current practice and is consistent with the risk-based 
capital standards' traditional focus on credit risk. The agencies have 
undertaken other initiatives to ensure that the risk-based capital 
standards take interest rate risk and other non-credit related market 
risks into account.
4. Implicit Recourse
    The definitions cover all arrangements that are recourse or direct 
credit substitutes in form or in substance. Recourse may also exist 
when an institution assumes risk of loss without an explicit 
contractual agreement or, if there is a contractual limit, when the 
institution assumes risk of loss in amounts exceeding the limit. The 
existence of implicit recourse is often a complex and fact-specific 
issue, usually demonstrated by an institution's actions beyond any 
contractual obligation. Actions that may constitute implicit recourse 
include: (a) Providing voluntary support for a securitization by 
selling assets to a trust at a discount from book value; (b) exchanging 
performing for non-performing assets; or (c) other actions that result 
in a significant transfer of value in response to deterioration in the 
credit quality of a securitized asset pool.
    To date, the agencies have taken the position that when an 
institution provides implicit recourse, it should generally hold 
capital in the same manner as for assets sold with recourse. However, 
because of the complexity and fact-specific nature of many implicit 
recourse arrangements, questions have been raised as to how much risk 
the institution has effectively retained as a result of its actions and 
whether a different capital treatment would be warranted in some 
circumstances. To assist the agencies in assessing various types of 
implicit recourse arrangements, comment is requested on the following:
    (Question 1) What types of actions should be considered implicit 
recourse, and how should the agencies treat these actions for 
regulatory capital purposes? Should the agencies establish different 
capital requirements for various types of implicit recourse 
arrangements? If so, how should appropriate capital requirements be 
determined for different types of implicit recourse arrangements? 
Please provide relevant data to support any recommended capital 
treatment.
    The agencies may issue additional interpretive guidance as needed 
to further clarify the circumstances in which an institution will be 
considered to have provided implicit recourse.
    One commenter responding to the 1994 Notice asked for clarification 
that a repurchase triggered by a breach of a standard representation or 
warranty (as defined below) would not be considered implicit recourse. 
Such a repurchase would not constitute implicit recourse because the 
repurchase is required by a contractual obligation created at the time 
of the sale.
5. Subordinated Interests in Loans or Pools of Loans
    The definitions of recourse and direct credit substitute explicitly 
cover an institution's ownership of subordinated interests in loans or 
pools of loans. This continues the Banking Agencies' longstanding 
treatment of retained subordinated interests as recourse and recognizes 
that purchased subordinated interests can also function as credit 
enhancements. (The OTS currently treats both retained and purchased 
subordinated securities as recourse obligations.) Subordinated 
interests generally absorb more than their pro rata share of losses 
(principal or interest) from the underlying assets in the event of 
default. For example, a multi-class asset securitization may have 
several classes of subordinated securities, each of which provides 
credit enhancement for the more senior classes. Generally, the holder 
of any class that absorbs more than its pro rata share of losses from 
the total underlying assets is providing credit protection for all more 
senior classes.<SUP>8</SUP>
---------------------------------------------------------------------------

    \8\ Current OTS risk-based capital guidelines exclude certain 
high-quality subordinated mortgage-related securities from treatment 
as recourse arrangements due to their credit quality. Consistent 
with these capital guidelines, the proposed OTS rule text includes 
the face value of high-quality subordinated mortgage-related 
securities in the 20% risk weight category.
---------------------------------------------------------------------------

    Two commenters questioned the treatment of purchased subordinated 
interests as recourse. Subordinated interests expose holders to 
comparable risk regardless of whether the interests are retained or 
purchased. If purchased subordinated interests were not treated as 
recourse, institutions could avoid recourse treatment by swapping 
retained subordinated interests with other institutions or by 
purchasing subordinated interests in assets originated by a conduit. 
The proposal would mitigate the effect of treating purchased 
subordinated interests as recourse by reducing the capital requirement 
on interests that qualify under the multi-level approach described in 
sections II.C, D, and E of this preamble.
6. Second Mortgages
    Second mortgages or home equity loans would generally not be 
considered recourse or direct credit substitutes, unless they actually 
function as credit enhancements by facilitating the sale of the first 
mortgage. For example, this may occur if a lender has a program of 
originating first and second mortgages contemporaneously on the same 
property and then selling the first mortgage and retaining the second. 
In such a program, a second mortgage can function as a substitute for a 
recourse arrangement because it is intended that the holder of the 
second mortgage will absorb losses before the holder of the first 
mortgage does if the borrower fails to make all payments due on both 
loans.
    The preamble to the 1994 Notice stated that a second mortgage 
originated

[[Page 59949]]

contemporaneously with the first mortgage would be presumed to be 
recourse. Many commenters criticized this position as overly broad. The 
agencies agree and do not propose to retain the presumption.
    However, the agencies expect institutions to follow prudent 
underwriting practices in making combined extensions of credit (i.e., a 
contemporaneous first and second mortgage loan) or other second 
mortgages to a single borrower. If an institution does not apply 
prudent underwriting standards in making combined loans, the agencies 
will consider this practice in determining whether the institution is 
using such mortgages to retain recourse and generally in evaluating the 
soundness of the institution's underwriting standards and in 
determining the adequacy of the institution's capital.
7. Representations and Warranties
    When a banking organization transfers assets, including servicing 
rights, it customarily makes representations and warranties concerning 
those assets. When a banking organization purchases loan servicing 
rights, it may also assume representations and warranties made by the 
seller or a prior servicer. These representations and warranties give 
certain rights to other parties and impose obligations upon the seller 
or servicer of the assets. The definitions in this proposal would treat 
as recourse or direct credit substitutes any representations or 
warranties that create exposure to default risk or any other form of 
open-ended, credit-related risk from the assets that is not 
controllable by the seller or servicer. This reflects the agencies' 
current practice with respect to recourse arising out of 
representations and warranties, and explicitly recognizes that a 
servicer with purchased loan servicing rights can also take on risk 
through servicer representations and warranties.
    The agencies recognize, however, that the market requires asset 
transferors and servicers to make certain representations and 
warranties, and that most of these present only normal operational 
risk. Currently, the agencies have no formal definitions distinguishing 
between these types of standard representations and warranties and 
those that create recourse or direct credit substitutes. The proposal 
therefore defines the term ``standard representations and warranties'' 
and provides that seller or servicer representations or warranties that 
meet this definition are not considered to be recourse obligations or 
direct credit substitutes.
    Under the proposal, ``standard representations and warranties'' are 
those that refer to an existing state of facts that the seller or 
servicer can either control or verify with reasonable due diligence at 
the time the assets are sold or the servicing rights are transferred. 
These representations and warranties will not be considered recourse or 
direct credit substitutes, provided that the seller or servicer 
performs due diligence prior to the transfer of the assets or servicing 
rights to ensure that it has a reasonable basis for making the 
representation or warranty. The term ``standard representations and 
warranties'' also covers contractual provisions that permit the return 
of transferred assets in the event of fraud or documentation 
deficiencies, (i.e., if the assets are not what the seller represented 
them to be), consistent with the current Call Report Instructions 
governing the reporting of asset transfers. After a final definition of 
``standard representations and warranties'' is adopted for the risk-
based capital standards, the Banking Agencies would recommend to the 
FFIEC that the Call Report Instructions be changed to conform to the 
capital guidelines and the OTS would similarly amend the instructions 
for the Thrift Financial Report (TFR).
    Examples of ``standard representations and warranties'' include 
seller representations that the transferred assets are current (i.e., 
not past due) at the time of sale; that the assets meet specific, 
agreed-upon credit standards at the time of sale; or that the assets 
are free and clear of any liens (provided that the seller has exercised 
due diligence to verify these facts). An example of a nonstandard 
representation and warranty is an agreement by the seller to buy back 
any assets that become more than 30 days past due or default within a 
designated time period after the sale. Another example of a nonstandard 
representation and warranty is a representation that all properties 
underlying a pool of transferred mortgages are free of environmental 
hazards. This representation is not verifiable by the seller or 
servicer with reasonable due diligence because it is not possible to 
absolutely verify that a property is, in fact, free of all 
environmental hazards. Such an open-ended guarantee against the risk 
that unknown but currently existing hazards might be discovered in the 
future would be considered recourse or a direct credit substitute. 
However, a seller's representation that all properties underlying a 
pool of transferred mortgages have undergone environmental studies and 
that the studies revealed no known environmental hazards would be a 
``standard representation and warranty'' (assuming that the seller 
performed the requisite due diligence). This is a verifiable statement 
of facts that would not be considered recourse or a direct credit 
substitute.
    Some commenters responding to the 1994 Notice supported this 
proposed definition. Many commenters addressing the definition opposed 
it. Commenters objected to the definition for the following reasons: 
treating representations and warranties as recourse would place banks 
at a competitive disadvantage with other institutions; representations 
and warranties are not equivalent to recourse because the risk involved 
may be considerably less than the risk of borrower default; and 
representations and warranties that relate to operational risk should 
not be recourse because recourse is supposed to address only credit 
risks. Some commenters suggested the agencies replace the due diligence 
requirement with a ``not known to be false'' standard.
    The agencies have decided to retain the proposed definition of 
standard representations and warranties for purposes of this proposal. 
Where a representation or warranty functions as recourse, failure to 
recognize the recourse obligation and to require appropriate capital 
would create a loophole that would defeat the purposes of the proposal.
    The definitions of ``recourse,'' ``direct credit substitute,'' and 
``standard representations and warranties'' are intended to treat as 
recourse or a direct credit substitute only those representations or 
warranties that create exposure to default risk or any other form of 
open-ended, credit-related risk from the assets that is not 
controllable by the seller or servicer. The agencies wish to clarify 
that only those representations and warranties that expose an 
institution to credit risk (as opposed to interest rate risk) will be 
classified as recourse or direct credit substitutes.
    The proposal would treat as recourse a representation or warranty 
that functions as recourse but that is guaranteed by a third party. The 
agencies request comment on whether the recourse rules should place 
assets subject to a representation or warranty that constitutes 
recourse in the 20 percent risk weight category if a third party 
guarantees the representation or warranty and has unsecured debt that 
is rated in the highest rating category.

[[Page 59950]]

8. Loan Servicing Arrangements
    The proposed definitions of ``recourse'' and ``direct credit 
substitute'' cover loan servicing arrangements if the servicer is 
responsible for credit losses associated with the loans being serviced. 
However, cash advances made by residential mortgage servicers to ensure 
an uninterrupted flow of payments to investors or the timely collection 
of the mortgage loans are specifically excluded from the definitions of 
recourse and direct credit substitute, provided that the residential 
mortgage servicer is entitled to reimbursement for any significant 
advances.<SUP>9</SUP> Such advances are assessed risk-based capital 
only against the amount of the cash advance, and are assigned to the 
risk-weight category appropriate to the party obligated to reimburse 
the servicer.
---------------------------------------------------------------------------

    \9\ Servicer cash advances include disbursements made to cover 
foreclosure costs or other expenses arising from a loan in order to 
facilitate its timely collection (but not to protect investors from 
incurring these expenses).
---------------------------------------------------------------------------

    If the residential mortgage servicer is not entitled to full 
reimbursement, then the maximum possible amount of any nonreimbursed 
advances on any one loan must be contractually limited to an 
insignificant amount of the outstanding principal on that loan in order 
for the obligation to make cash advances to be excluded from the 
definitions of recourse and direct credit substitute. This treatment 
reflects the agencies' traditional view that servicer cash advances 
meeting these criteria are part of the normal mortgage servicing 
function and do not constitute credit enhancements.
    Commenters generally supported the proposed definition of servicer 
cash advances. Some commenters asked for clarification of the terms 
``insignificant'' and whether ``reimbursement'' includes reimbursement 
payable out of subsequent collections or reimbursement in the form of a 
general claim on the party obligated to reimburse the servicer. 
Nonreimbursed advances contractually limited to no more than one 
percent of the amount of the outstanding principal would be considered 
insignificant. Reimbursement includes reimbursement payable from 
subsequent collections and reimbursement in the form of a general claim 
on the party obligated to reimburse the servicer, provided that the 
claim is not subordinated to other claims on the cash flows from the 
underlying asset pool.
9. Spread Accounts and Overcollateralization
    Several commenters requested that the agencies state in their rules 
that spread accounts and overcollateralization do not impose a risk of 
loss on an institution and are not recourse. By its terms, the 
definition of recourse covers only the retention of risk in a sale of 
assets. Neither a spread account (unless reflected on an institution's 
balance sheet) nor overcollateralization ordinarily impose a risk of 
loss on an institution, so neither would fall within the proposed 
definition of recourse. However, a spread account reflected as an asset 
on an institution's balance sheet would be a form of recourse or direct 
credit substitute and would be treated accordingly for risk-based 
capital purposes.

B. Treatment of Direct Credit Substitutes

    The agencies are proposing to extend the current risk-based capital 
treatment of asset transfers with recourse, including the low-level 
recourse rule, to direct credit substitutes. As previously explained, 
the current risk-based capital assessment for a direct credit 
substitute such as a standby letter of credit may be dramatically lower 
than the assessment for a recourse provision that creates an identical 
exposure to risk. As noted previously, the OTS capital rule already 
treats most direct credit substitutes (other than financial standby 
letters of credit) in the same manner as recourse obligations.
    Currently, an institution that sells assets with 10 percent 
recourse must hold capital against the full amount of the assets 
transferred. On the other hand, an institution that extends a letter of 
credit covering the first 10 percent of losses on the same pool of 
assets must hold capital against only the face amount of the letter of 
credit. Banking organizations are taking advantage of this anomaly by 
providing first loss letters of credit to asset-backed commercial paper 
conduits that lend directly to corporate customers, which results in a 
significantly lower capital requirement than if the loans had been on 
the organizations' balance sheets and were sold with recourse.
    In the 1994 Notice, the agencies proposed to change only the 
treatment of direct credit substitutes that absorb the first dollars of 
losses from the assets enhanced. The agencies proposed to delay 
changing the treatment of other direct credit substitutes until a 
multi-level approach could be implemented. Some commenters suggested 
that the agencies adopt a comprehensive approach, implementing a change 
in the treatment of direct credit substitutes only in the context of a 
multi-level approach, and observed that a piecemeal approach would be 
unduly disruptive. The agencies agree and now propose to implement the 
change in the treatment of direct credit substitutes in combination 
with the multi-level approach. As proposed, the multi-level approach 
applies to direct credit substitutes and recourse obligations related 
to asset securitizations. The agencies request comment on how the final 
rule could prudently and effectively apply the multi-level approach to 
direct credit substitutes and recourse obligations not related to asset 
securitizations.
    Several commenters objected to the proposed treatment of direct 
credit substitutes as recourse. Commenters objected that the proposed 
capital treatment would impair the competitive position of U.S. banks 
and thrifts and that the business of providing third-party credit 
enhancements has historically been safe and profitable for banks. 
Notwithstanding these concerns, the agencies believe that the current 
treatment of direct credit substitutes is not consistent with the 
treatment of recourse obligations, and that the difference in treatment 
between the two forms of credit enhancement invites institutions to 
convert recourse obligations into direct credit substitutes in order to 
avoid the capital requirement applicable to recourse obligations and 
balance-sheet assets. The agencies request comment on the proposed 
treatment of direct credit substitutes and on the effect of the 
proposed treatment on the competitive position of U.S. banks.
    The Banking Agencies have raised the issue of increasing the 
capital requirement for direct credit substitutes and lowering the 
capital requirement for highly-rated senior securities with the bank 
supervisory authorities from the other countries represented on a 
subgroup of the Basle Committee on Banking Supervision in an effort to 
eliminate competitive inequities.

C. Multi-level Ratings-based Approach

    Many asset securitizations carve up the risk of credit losses from 
the underlying assets and distribute it to different parties. A credit 
enhancement (that is, a recourse arrangement or direct credit 
substitute) that has no prior loss protection is a ``first dollar'' 
loss position. There may be one or more layers of additional credit 
enhancement after the first dollar loss position. Each loss position 
functions as a credit enhancement for the more senior loss

[[Page 59951]]

positions in the structure. Currently, the risk-based capital standards 
do not vary the rate of capital assessment with differences in credit 
risk represented by different credit enhancement or loss positions.
    To address this issue, the agencies are proposing a ``multi-level'' 
approach to assessing capital requirements on recourse obligations, 
direct credit substitutes, and senior securities in asset-
securitizations based on their relative exposure to credit risk. The 
agencies are proposing a ratings-based approach that would use credit 
ratings from the rating agencies to measure relative exposure to credit 
risk and to determine the associated risk-based capital requirement. 
The use of credit ratings would provide a way for the agencies to use 
market determinations of credit quality to identify different loss 
positions for capital purposes in an asset securitization structure. 
This may permit the agencies to give more equitable treatment to a wide 
variety of transactions and structures in administering the risk-based 
capital system.
    Under the ratings-based approach, the capital requirement for a 
recourse obligation, direct credit substitute, or senior security would 
be determined as follows: <SUP>10</SUP>
---------------------------------------------------------------------------

    \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.
---------------------------------------------------------------------------

    <bullet> A position rated in the highest investment grade rating 
category would receive a 20 percent risk weight.
    <bullet> 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.)
    <bullet> 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.<SUP>11</SUP>
---------------------------------------------------------------------------

    \11\ Under the ``gross-up'' treatment, a position is combined 
with all more senior positions in the transaction. The result is 
then risk-weighted based on the nature of the underlying assets. For 
example, if an institution retains a first-loss position in a pool 
of mortgage loans that qualify for a 50 percent risk weight, the 
institution would include the full amount of the assets in the pool, 
risk-weighted at 50 percent, in its risk-weighted assets for 
purposes of determining its risk-based capital ratio. The ``low 
level'' recourse rule limits the capital requirement for recourse 
obligations to the institution's maximum contractual obligation. 12 
U.S.C. 4808.
---------------------------------------------------------------------------

    If a recourse obligation, direct credit substitute, or senior 
security receives different ratings from the rating agencies, the 
highest ratings would determine the capital treatment. For traded 
positions, the single highest rating would apply. For positions that 
require two ratings (see section II.C.3 of this preamble), the lower of 
the two highest ratings would apply.
1. 1994 Notice
    The 1994 Notice described, in an advance notice of proposed 
rulemaking, a ratings-based approach under which investment grade 
positions rated in the highest rating category would receive a 20 
percent risk weight and other investment grade positions would receive 
a 100 percent risk weight. Some commenters responding to the 1994 
Notice supported the ratings-based approach described in that notice as 
a flexible, efficient, market-oriented way to measure risk in 
securitizations. Many commenters also noted that a ratings-based 
approach was not a perfect or complete solution, especially for non-
traded positions that would otherwise not need to be rated. The 
agencies recognize additional options for non-traded positions could be 
useful in conjunction with or in lieu of the ratings-based approach and 
are considering other approaches, which are described in section II.E 
of this preamble.
    In the 1994 Notice the agencies suggested that a ratings-based, 
multi-level approach should be restricted to transactions involving the 
securitization of large, diversified asset pools in which all forms of 
first dollar loss credit enhancement are either completely free of 
third-party performance risk or are provided internally as part of the 
securitization structure. Additionally, the agencies had suggested that 
the ratings-based approach be available only for positions other than 
first-loss positions. Many commenters pointed out that credit ratings 
incorporate this information and that the threshold criteria were 
redundant. The agencies agree and have not included these criteria in 
the proposal.
2. Effect of Ratings Downgrades
    The ratings-based approach would be based on current ratings, so 
that a rating downgrade or withdrawal of a rating could change the 
treatment of a position under the proposal. However, a downgrade by a 
single rating agency rating would not affect the capital treatment of a 
position if the position still qualified for the treatment under 
another rating from a different rating agency.
3. Non-traded Positions
    In response to the 1994 Notice, one rating agency expressed concern 
that regulatory use of ratings could undermine the integrity of the 
rating process.<SUP>12</SUP> Ordinarily, according to the commenter, 
there is a tension between the interests of the investors who rely on 
ratings and the interests of the issuers who pay rating agencies to 
generate ratings. Under the ratings-based approach, the holder of a 
recourse obligation or direct credit substitute that is not traded or 
sold may, in some cases, ask for a rating just to qualify for a 
favorable risk weight. The rating agency expressed a strong concern 
that, without the counterbalancing interest of investors who will be 
relying on the rating, rating agencies may have an incentive to issue 
inflated ratings.
---------------------------------------------------------------------------

    \12\ See T. McGuire, Moody's Investors Service, Ratings in 
Regulation: A Petition to the Gorillas (1995).
---------------------------------------------------------------------------

    In response to this concern, the agencies have developed proposed 
criteria to reduce the possibility of inflated ratings and 
inappropriate risk weights if ratings are used for a position that is 
not traded. The agencies are proposing that such a position could 
qualify for the ratings-based approach if: (1) It qualifies under 
ratings from two different rating agencies; (2) the ratings are 
publicly available; (3) the ratings are based on the same criteria used 
to rate securities sold to the public; and (4) at least one position in 
the securitization is traded.
    For purposes of this proposal a position is considered ``traded'' 
if, at the time it is rated, there is a reasonable expectation that in 
the near future: (1) The position may be sold to investors relying on 
the rating or (2) a third party may enter into a transaction such as a 
loan or repurchase agreement involving the position in which the third 
party relies on the rating of the position.
    In Section II.E of this preamble, the agencies describe two 
alternative approaches to the ratings-based approach for non-traded 
securitization positions: the ``ratings benchmark'' approach and the 
``historical loss'' approach. The agencies may decide to adopt either 
or both of these approaches, or portions of them, to either replace or 
supplement the ratings-

[[Page 59952]]

 based approach for non-traded positions.
    (Question 2) How could the agencies prudently and effectively apply 
the multi-level approach to direct credit substitutes and recourse 
obligations not related to asset securitizations?
    (Question 3) What would be the most appropriate oversight mechanism 
for verifying ratings on nontraded positions? For instance, should an 
institution be required to obtain a detailed explanation from the 
rating agency of the basis for the rating on the non-traded position? 
Should the institution be required to make this substantiating 
information available to the regulatory agencies for review purposes?
    (Question 4) How can the agencies determine if a rating on a non-
traded position is inappropriately high? Does any available evidence 
show that regulatory rules based on ratings for traded positions have 
led to inappropriately high ratings?
    (Question 5). For a rated position to be considered traded, an 
institution must have a reasonable expectation when the position is 
rated that a sale or other transaction involving the position will take 
place in the near future. The agencies request comment on this 
definition and on the time period that is appropriate to use for 
defining the ``near future.''

D. Face Value and Modified Gross-up Alternatives for Investment Grade 
Positions Below the Highest Investment Grade Rating

1. Description of Approaches
    The agencies are seeking comment on two alternative approaches for 
calculating the capital requirement for investment grade positions 
rated below the highest investment grade level (i.e., 
AAA).<SUP>13</SUP> One alternative, the ``face value'' approach, would 
apply a 100 percent risk weight to the book value or face amount of all 
investment grade positions below the highest investment grade level, 
regardless of their position within a securitization structure. The 
other alternative, the ``modified gross-up'' approach, would gross-up 
all investment grade positions below the highest investment grade level 
and then apply a 50 percent risk weight to the grossed-up amount. For 
senior investment grade positions below the highest investment grade 
level, this approach would have the effect of applying a 50 percent 
risk weight to these positions.<SUP>14</SUP> The agencies seek comment 
on which of these two alternative approaches should be adopted or on 
possible alternatives to the two described here.
---------------------------------------------------------------------------

    \13\ The option that is chosen would be applicable to the 
ratings benchmark and historical loss approaches discussed later in 
this preamble.
    \14\ If a subordinated position receives the highest investment 
grade rating, it would not be grossed up under the modified gross-up 
approach. This is due to the relatively low risk implied by the 
rating.
---------------------------------------------------------------------------

    a. Rationale for the Modified Gross-Up Proposal.--The modified 
gross-up approach is being proposed because of a concern that junior 
positions that represent only a small portion of a securitization (so-
called ``thin-strip'' mezzanine positions) may qualify for an 
investment grade rating despite a concentration of risk on the position 
that makes them substantially more risky than investment grade whole 
securities with the same underlying collateral. Some rating agencies do 
not take into account the severity of loss posed by this risk 
concentration when rating these mezzanine positions. Other rating 
agencies do so in a way that may be insufficient for risk-based capital 
purposes. (See detailed explanations in subsections b and c).
    An underlying premise of the modified gross-up approach is that an 
investment grade thin-strip mezzanine piece likely poses more risk of a 
larger percentage loss than a similarly rated whole asset-backed 
security. This additional risk is related to the variability of losses 
on the mezzanine position.<SUP>15</SUP>
---------------------------------------------------------------------------

    \15\ The variability of loss can be characterized by its 
variance, which measures the distribution of potential losses around 
the expected loss. The larger the variance, the more likely that the 
actual outcome will be further away from the expected loss. For 
example, consider two securities with the same expected loss. The 
first security has two possible loss scenarios, $7 and $13, that 
each have a probability of 50 percent. The expected loss on this 
security is $10, but its variance is 9 and its standard deviation is 
3. A second security has two possible loss scenarios, $0 and $20, 
that also have probabilities of 50 percent. The expected loss on 
this security is also $10, but its variance is 100 and its standard 
deviation is 10. The variances and standard deviations for the two 
securities are very different. From a capital adequacy standpoint, 
the second security poses a greater risk of loss than the first 
security. Hence, the second security should have a larger capital 
cushion, even though the expected loss on both positions is the 
same.
---------------------------------------------------------------------------

    Additionally, there is some evidence that investors account for the 
additional concentration of credit risk in thin-strip mezzanine 
positions by demanding higher yields for these positions. This is 
especially the case for ratings that do not account for severity of 
loss on the mezzanine position.
    The modified gross-up capital treatment is designed to account for 
the fact that a thin-strip mezzanine position and whole security with 
the same credit ratings have similar credit risks and should, 
therefore, have similar dollar capital requirements. Relative to the 
``face value'' treatment, it would more fully account for the 
concentration risk in these positions as it relates to the current 
risk-based capital framework.
    The modified gross-up proposal would gross-up mezzanine positions 
to take into account any additional credit risk concentration that may 
not be fully captured by the ratings. However, if such positions are 
rated investment grade, but are below the highest investment grade 
level, this proposal would place their grossed-up amounts in the 50 
percent risk weight category. In addition, senior investment grade 
positions below the highest investment grade level would be placed in 
the 50 percent risk weight category. The 50 percent risk weight was 
selected because it lies between the agencies' proposed 20 percent risk 
weight for the highest investment grade level and the 100 percent risk 
weight that applies to most positions below investment grade that would 
be fully grossed-up in this proposed rule.
    b. Concerns with Ratings Based on Probability of Default. The 
agencies understand that certain rating agencies base their ratings on 
the probability that the position will experience any losses, 
regardless of the severity of loss on the position. These types of 
ratings will be referred to as ``probability of default'' ratings.
    If a rating for a security is based solely on the probability of 
default (i.e., the probability of any losses), both a whole asset-
backed security and a junior security carved out of that whole security 
will receive exactly the same rating. Both securities have the same 
probability of default. Since the junior piece is smaller than the 
whole security, any losses on the security's underlying loan pool will 
create a larger loss as a percentage of the junior piece (i.e., a 
higher loss severity) than the percentage loss on the larger whole 
security.
    Consider the following: Assume that $1,050 in commercial loans are 
used to create a $1,000 whole security, Security 1, and a $50 credit 
enhancement supporting Security 1. The $1,000 security receives the 
lowest investment grade rating (BBB), based on the $50 credit 
enhancement (the C piece). The $1,000 security is subsequently divided 
into two pieces, a $900 senior piece, Security 2A (the A piece), and a 
$100 junior piece, Security 2B (the B piece, which is the mezzanine 
position between the A and C pieces). The senior piece receives a AAA 
rating because its probability of default has decreased. The junior 
piece, on its own, will still receive a BBB rating because its

[[Page 59953]]

probability of default is the same as the $1,000 whole security prior 
to dividing the whole security into two pieces. The percentage impact 
of any unexpected losses on the junior piece, though, can be many times 
greater than that on the whole security because any losses on the 
underlying pool of loans will be absorbed by the smaller principal 
amount of the junior security. (See Figure 1.)
    Assume that most of the risk of credit loss for the $1,050 pool of 
commercial loans described previously is concentrated in the bottom 
$150 portion of the loans. The credit enhancement (the C piece) would 
absorb the first $50 of losses. The $100 junior piece (i.e., Security 
2B, the mezzanine position) would, therefore, contain the balance of 
the credit risk of the $1,000 whole security. Since most of the credit 
risk of the $1,000 whole security is concentrated in this junior piece, 
for capital adequacy purposes, the appropriate dollar capital charge on 
the $100 junior piece and the $1,000 security should, in theory, be 
approximately the same. This would produce an equal capital buffer for 
positions with approximately equal credit risk. On a percentage basis, 
applying the same dollar capital charge against this mezzanine position 
and the whole security results in a ten-times higher percentage 
requirement on the mezzanine position than the ``face value'' option 
because its face value is one-tenth the size of the whole security 
($100 versus $1,000).
    c. Concerns with Ratings Based on Expected Losses. The agencies 
understand that some ratings are provided based on expected losses 
(i.e., the sum of all the possible losses weighted by the probabilities 
of their occurrence) rather than just the probability of default. This 
approach takes into account both the severity and likelihood of losses, 
and therefore addresses some of the problems presented by the 
probability of default approach. Rating agencies that use the expected 
loss approach require a small increase in the credit enhancement (the C 
piece) supporting the junior piece (Security 2B) in order for this 
piece to obtain the same credit rating as the whole security (Security 
1). While this additional credit enhancement is required to account for 
the concentration of credit risk in the junior piece, for risk-based 
capital purposes, the enhancement may not fully compensate for this 
concentration risk. (Figure 2)
    d. Concerns About Modified Gross-up Proposal. There is some concern 
that the additional capital that the modified gross-up approach 
requires for certain situations may be disproportionate to the extent 
to which ratings, in fact, fail to capture the concentration of risk in 
mezzanine positions. In particular, for multi-tier securitizations that 
have several investment grade tiers below the highest investment grade 
rating, the modified gross-up approach may require too much capital 
when all tiers are held in the banking system because each tier would 
be grossed up and placed in the 50 percent risk weight category. 
Example 4 illustrates this concern.
    (Question 6). The agencies request comments comparing the face 
value treatment with the modified gross-up treatment, and on other 
refinements the agencies could consider to address their concerns 
regarding the capital charge that would apply to thin-strip mezzanine 
positions under the ratings-based approach.
    (Question 7). For the modified gross-up approach, the agencies have 
some concern that a 50 percent risk-weighting may be inappropriate to 
apply to the grossed-up positions of securitizations. If this is the 
case, what should the alternative risk weight be for the grossed-up 
security and what data are available to support this alternative risk 
weight?
    (Question 8). For a thin-strip mezzanine position, a rating agency 
that uses the expected losses approach requires a higher credit 
enhancement to obtain a specified rating than a rating agency that uses 
the probability of loss approach because the former takes into account 
the loss severity of the position. Should the agencies have different 
capital standards based on which of the two approaches is used for 
determining the rating for the position?

BILLING CODE 4810-33-P

[[Page 59954]]

[GRAPHIC] [TIFF OMITTED] TP05NO97.000



BILLING CODE 4810-33-C

[[Page 59955]]

2. Examples of Face Value and Modified Gross-up Approaches
    The capital requirements under the modified gross-up approach would 
differ substantially from a face-value treatment. The modified gross-up 
approach results in a higher capital requirement for thin-strip BBB-
rated mezzanine positions than the face value approach. On the other 
hand, for senior BBB-rated positions, the modified gross-up approach 
results in a lower capital requirement than the face value approach.
    For instance, based on the example cited previously, the modified 
gross-up approach for the $100 BBB-rated mezzanine position (Security 
2B) would produce a capital charge of $40 (the grossed-up amount which 
is equal to Security 2A plus Security 2B, $1,000, times 50 percent 
times 8 percent) while the face value approach would produce a capital 
requirement of $8 (the face amount of Security 2B, $100, times 100 
percent times 8 percent). For the $1,000 senior BBB-rated position 
(Security 1, the whole security), the modified gross-up approach would 
produce a capital requirement of $40 ($1,000 times 50 percent times 8 
percent) while the face value approach would produce a capital 
requirement of $80 ($1,000 times 100 percent times 8 percent).
    The four following examples illustrate, for various types of 
securitization structures, the capital requirements for thrifts and 
banks under current rules and under the proposed face value and 
modified gross-up alternatives.

Example 1

    Bank A issues three classes of securities that are backed by a 
$100 million pool of loans. These classes include a bottom-level 
(first-loss) subordinated class of $11 million, a publicly-traded 
middle-level subordinated class of $9 million, and a publicly-traded 
senior class of $80 million. Bank A retains the bottom-level class 
and sells the other two classes to other banks or thrifts.
    Under the face value and modified gross-up approaches, Bank A, 
retaining the bottom-level subordinated class, would be required to 
hold risk-based capital equal to 8 percent of the $100 million pool 
or $8 million (the full effective risk-based capital requirement for 
the outstanding amount of the assets enhanced). Assume that because 
the subordinated class provides sufficient first dollar loss 
enhancement, a nationally recognized statistical rating organization 
gives the $9 million publicly-traded middle class the lowest 
investment grade rating. Under the face value approach, the capital 
requirement for an institution holding the position would be 8 
percent of $9 million or $720 thousand. Under the modified gross-up 
approach the capital requirement is 4 percent (50 percent times 8 
percent) of the grossed-up amount of $89 million ($9 million plus 
$80 million) or $3.56 million. Finally, assume that the $80 million 
senior class receives the highest credit rating, which qualifies it 
for a 20 percent risk weight under both approaches. The capital 
requirement for an institution holding this piece would be 1.6 
percent (20 percent times 8 percent) of $80 million or $1.28 
million. Table 1 summarizes this example.

                                                                Table 1.--A-B-C Structure                                                               
                                                 [Underlying Assets--$100 million of Non-Mortgage Loans]                                                
--------------------------------------------------------------------------------------------------------------------------------------------------------
                                                                                              Current         Current                                   
                                                                                              capital         capital       Face value    Modified gross-
                   Position                     Size  ($           Credit  rating           requirement     requirement    approach  ($     up approach 
                                                  mil)                                      for thrifts    for banks  ($       mil)           ($ mil)   
                                                                                              ($ mil)          mil)                                     
--------------------------------------------------------------------------------------------------------------------------------------------------------
A............................................         $80  AAA..........................           $6.40           $6.40           $1.28           $1.28
B............................................           9  BBB..........................            7.12            0.72            0.72            3.56
C............................................          11  Unrated......................            8.00            8.00            8.00            8.00
                                                                                         ---------------------------------------------------------------
    Total Capital............................  ..........  .............................           21.52           15.12           10.00           12.84
--------------------------------------------------------------------------------------------------------------------------------------------------------

Example 2

    Bank A issues two classes of securities that are backed by a 
$100 million pool of loans. These classes include a bottom-level 
(first-loss) subordinated class of $20 million and a publicly-traded 
senior class of $80 million. Bank A retains the bottom-level class 
and sells the senior class to other banks or thrifts.
    Under both the face value and the modified gross-up approaches, 
Bank A, retaining the bottom-level subordinated class, would be 
required to hold risk-based capital equal to 8 percent of the $100 
million pool or $8 million (the full effective risk-based capital 
requirement for the outstanding amount of the assets enhanced). 
Assume that because the subordinated class provides sufficient first 
dollar loss enhancement, a nationally recognized statistical rating 
organization gives the $80 million publicly-traded senior class an A 
rating. Under the face value approach, the capital requirement for 
an institution holding position would be 8 percent of $80 million or 
$6.4 million. Under the modified gross-up approach, the capital 
requirement is 4 percent (50 percent times 8 percent) of the 
grossed-up amount of $80 million (which, in this case, is the senior 
piece) or $3.2 million. Table 2 summarizes this example.

                                                                 Table 2.--A-B Structure                                                                
                                                 [Underlying Assets--$100 million of Non-Mortgage Loans]                                                
--------------------------------------------------------------------------------------------------------------------------------------------------------
                                                                                              Current         Current                                   
                                                                                              capital         capital       Face value    Modified gross-
                   Position                     Size  ($           Credit  rating           requirement     requirement    approach  ($     up approach 
                                                  mil)                                      for thrifts    for banks  ($       mil)           ($ mil)   
                                                                                              ($ mil)          mil)                                     
--------------------------------------------------------------------------------------------------------------------------------------------------------
A............................................         $80  A............................           $6.40           $6.40           $6.40           $3.20
B............................................          20  Unrated......................            8.00            8.00            8.00            8.00
                                                                                         ---------------------------------------------------------------
    Total Capital............................  ..........  .............................           14.40           14.40           14.40           11.20
--------------------------------------------------------------------------------------------------------------------------------------------------------

Example 3

    Bank A issues four classes of securities that are backed by a 
$100 million pool of mortgage loans. These classes include a bottom-
level (first-loss) subordinated class of $0.75 million (the D 
position), two thin publicly-traded middle-level subordinated 
classes (the B and C positions, $1.5 and $0.75 million, 
respectively), and a senior class of $97 million which meets the 
requirements for a SMMEA security. Bank A retains the bottom-level 
class and sells the other three

[[Page 59956]]

classes to banks or thrifts. (Under current rules, the Banking 
Agencies apply a 100 percent risk weight to the B and C positions, 
even though the underlying assets have a 50 percent risk weight, 
because the B and C positions are subordinated.)
    Under both the face value and the modified gross-up approaches, 
Bank A, retaining the bottom-level subordinated class, would be 
required to hold risk-based capital equal to 4 percent of the $100 
million pool, limited to its $0.75 million maximum exposure (low-
level recourse). Assume that because the subordinated class provides 
sufficient prior credit enhancement to the classes above it, a 
nationally recognized statistical rating organization gives the two 
publicly-traded middle classes ratings of BBB and A and the senior 
class a rating of AAA. The capital requirements for the various 
tranches are as follows. The current treatment for banks holding the 
$97 million AAA-rated senior mortgage position is to apply a 50 
percent risk weight to the position resulting in a capital 
requirement of $3.88 million ($97 million times 50 percent times 8 
percent). The current treatment for thrifts holding this $97 million 
position is to apply a 20 percent risk weight to the position 
resulting in a capital requirement of $1.552 million ($97 million 
times 20 percent times 8 percent). Under both the face value and 
modified gross-up approaches, the 20 percent risk weight would apply 
to the $97 million position. For the two investment grade positions 
below AAA (the B and C positions), the current thrift rules require 
full gross-up of the positions and the resulting capital requirement 
is subject to the low-level recourse rule that limits the 
requirement to the size of the position. The modified gross-up 
approach results in a capital requirement exceeding the size of the 
position and would also be subject to the low-level rule. The 
current bank rules, which use the face value approach, would apply a 
100 percent risk weight to the position. Table 3 summarizes this 
example.

                                                            Table 3--Multi-Tranche Structure                                                            
                                       [Underlying Assets--$100 million of 50 percent Risk-Weight Mortgage Loans]                                       
--------------------------------------------------------------------------------------------------------------------------------------------------------
                                                                                              Current         Current                                   
                                                                                              capital         capital       Face value    Modified gross-
                   Position                     Size  ($           Credit  rating           requirement     requirement    approach  ($     up approach 
                                                  mil)                                      for thrifts    for banks  ($       mil)           ($ mil)   
                                                                                              ($ mil)          mil)                                     
--------------------------------------------------------------------------------------------------------------------------------------------------------
A............................................       $97.0  AAA..........................          $1.552          $3.880          $1.552          $1.552
B............................................         1.5  A............................           1.500           0.120           0.120           1.500
C............................................        0.75  BBB..........................           0.750           0.060           0.060           0.750
D............................................       10.75  Unrated......................           0.750           0.750           0.750           0.750
    Total Capital............................  ..........  .............................           4.552           4.810           2.482           4.552
--------------------------------------------------------------------------------------------------------------------------------------------------------

Example 4

    A bank issues seven classes of securities (A through G) backed 
by a $100 million pool of loans and retains a junior $6 million 
subordinated interest. Additional credit enhancement available to 
the class G securities enables those securities to obtain an A 
rating. The other positions are rated as indicated in Table 4.

                                                            Table 4--Multi-Tranche Structure                                                            
                                                 [Underlying Assets--$100 million of Non-Mortgage Loans]                                                
--------------------------------------------------------------------------------------------------------------------------------------------------------
                                                                                              Current         Current                                   
                                                                                              capital         capital       Face value    Modified-gross-
                   Position                     Size  ($           Credit  rating           requirement     requirement    approach  ($     up approach 
                                                  mil)                                      for thrifts    for banks  ($       mil)           ($ mil)   
                                                                                              ($ mil)          mil)                                     
--------------------------------------------------------------------------------------------------------------------------------------------------------
A............................................         $32  AAA..........................           $2.56           $2.56            0.51            0.51
B............................................          21  AAA..........................            4.24            1.68            0.34            0.34
C............................................          17  AAA..........................            5.60            1.36            0.27            0.27
D............................................           6  AA...........................            6.00            0.48            0.48            3.04
E............................................           6  A............................            6.00            0.48            0.48            3.28
F............................................           6  BBB..........................            6.00            0.48            0.48            3.52
G............................................           6  A............................            6.00            0.48            0.48            3.76
Retained.....................................           6  Unrated......................            6.00            6.00            6.00            6.00
    Total Capital............................  ..........  .............................           42.40           13.52            9.04           20.72
--------------------------------------------------------------------------------------------------------------------------------------------------------

E. Alternative Approaches

1. Ratings Benchmark Approach
    a. Description of Approach. Because of some concerns with the use 
of the ratings-based approach for non-traded positions, the agencies 
are considering another alternative--the ratings benchmark approach. 
Under this alternative, the agencies would issue benchmark guidelines 
that would be used in assessing the relative credit risk of non-traded 
positions in specified standardized securitization structures. The 
ratings benchmarks would set credit enhancement requirements and other 
pool standards for such securitizations. If a non-traded position in 
such a securitization fulfills the applicable standards, and the 
securitization structure includes at least one traded position, the 
non-traded position will be eligible for the same capital treatment as 
investment-grade positions under the ratings-based approach.
    The agencies are considering this approach: (1) To recognize and 
build on consensus in the market regarding the amount of prior credit 
enhancement and pool standards necessary to obtain an ``A'' rating from 
the rating agencies; (2) To reduce the cost and regulatory burden of 
requiring institutions to obtain ratings on non-traded positions in 
such securitizations; and (3) To ensure that the agencies retain 
supervisory discretion to supplement the rating agencies' standards by 
adding criteria that the agencies consider essential to protect the 
safe operation of insured institutions.
    b. Development and Application of Ratings Benchmarks. The credit 
enhancement requirements and other pool standards for each type of 
securitization would be based on information available from the rating 
agencies regarding the relative credit risk of various types of asset 
pools. The ratings benchmark for each type of pool

[[Page 59957]]

would be based on the rating agencies' requirements for credit 
enhancement and other pool standards necessary for the assignment of an 
``A'' rating. Relying on the ``A'' rating standard provides assurance 
of a level of credit quality and permits the use of a relatively simple 
benchmark, while ensuring that the noninvestment-grade positions are 
not given preferential capital treatment.
    The agencies would limit the application of the ratings benchmark 
approach to positions in a securitization structure in which there is 
at least one traded position. This limitation is intended to ensure 
that the pool standards imposed on securitizations by the rating agency 
selected to rate the traded position would provide an extra measure of 
protection reinforcing the agencies' benchmark standards.
    To be eligible for the capital treatment under the ratings 
benchmark approach, the benchmarks would require a specified amount of 
prior credit enhancement based on the type of asset securitization 
involved. Recourse arrangements and direct credit substitutes that fail 
to satisfy the applicable benchmarks would be grossed-up.<SUP>16</SUP>
---------------------------------------------------------------------------

    \16\ If a non-traded position failed to comply with any revised 
benchmark standards for the specific asset type, the position would 
be subject to the gross-up approach.
---------------------------------------------------------------------------

    Under the ratings benchmark approach, qualifying prior credit 
enhancements include: cash collateral accounts,<SUP>17</SUP> 
subordinated interests or classes of securities; spread 
accounts,<SUP>18</SUP> including those funded initially with a loan 
repaid from excess cash flow; and other forms of overcollateralization 
involving excess cash flows (e.g., placing excess receivables into the 
pool so that total cash flows expected to be received exceed cash flows 
required to pay investors). These forms of credit enhancement are 
consistent with the proposal contained in the 1994 Notice which defined 
prior credit enhancement for the purposes of applying the multi-level 
ratings based approach.
---------------------------------------------------------------------------

    \17\ A cash collateral account is a separate account funded with 
a loan from the provider of the credit enhancement. Funds in the 
account are available to cover potential losses.
    \18\ A spread account is typically a trust or special account 
that the issuer establishes to retain interest rate payments in 
excess of the sum of the amounts due investors from the underlying 
assets, plus a normal servicing fee rate. The excess spread serves 
as a cushion to cover potential losses on the underlying loans.
---------------------------------------------------------------------------

    Consistent with comments received on the 1994 Notice and the types 
of credit enhancement generally relied on by the ratings agencies in 
rating asset pools, the agencies would also permit forms of prior 
credit enhancement involving third-party performance risk. 
Specifically, the agencies would permit: pool insurance, financial 
guarantees, and standby letters of credit issued or guaranteed by 
companies rated or whose debt is rated, in the highest two investment 
categories by two rating agencies or similar rating organizations. 
Third party credit enhancements would qualify under the ratings 
benchmark approach if: (1) the credit enhancement absorbs credit losses 
before an institution's non-traded position absorbs losses; and (2) the 
credit enhancement represents an unconditional obligation of the third 
party providing the enhancement.
    c. Computation of Capital Requirements under the Ratings Benchmark 
Approach. Non-traded positions in asset securitizations meeting the 
benchmark standards would receive the same capital treatment as 
investment grade positions under the ratings-based approach (i.e., 
either the face value treatment or the modified gross-up treatment). 
Eligible positions would not be subject to the full gross-up treatment.
    If the agencies have not developed a ratings benchmark for a 
specific type of transaction, or if a position in a securitization 
structure does not qualify under an established benchmark, the non-
traded position will be subject to the full gross-up approach, unless 
it otherwise qualifies for the multi-level treatment under some other 
approach for non-traded positions ultimately adopted in this 
rulemaking.
    d. Publication of Benchmarks. Initial benchmarks are provided for 
securitizations backed by residential mortgages, credit cards, auto 
loans, trade receivables, and commercial real estate. The prior credit 
enhancement requirements and other pool standards contained in these 
initial benchmarks have been based on discussions with rating agencies 
and public information submitted to the agencies in this rulemaking. 
<SUP>19</SUP> Public comment is solicited on all aspects of the ratings 
benchmark approach, including the standards contained in the 
benchmarks.
---------------------------------------------------------------------------

    \19\ See Duff and Phelps Credit Rating Company Presentation to 
Federal Financial Institutions Examinations Council (April 18, 
1995). This document is available for public review in the FFIEC 
public reference room at 2100 Pennsylvania Avenue, NW., Suite 200 
Washington, DC. The benchmarks in this document, however, do not 
purport to reflect the current standards of that company or any 
specific rating agency.
---------------------------------------------------------------------------

    If the ratings benchmark approach is adopted, the agencies would 
update the benchmarks at least once every two years based on a survey 
of rating agencies. The revisions to the benchmarks for each asset type 
would be based on the average of the two highest enhancement 
requirements of the rating agencies responding to a survey.
    Additionally, if this approach is adopted, the agencies would 
establish new benchmarks for additional types of securitizations based 
on continuing discussions with insured institutions and rating agencies 
regarding appropriate pool standards and market developments. New 
benchmarks would be issued only for types of securitizations for which 
the agencies believe there is a market consensus on: (1) The amount of 
prior credit enhancement; and (2) the pool standards that such 
securitization positions generally must satisfy to obtain the 
equivalent of an ``A'' rating from rating agencies.
    The biennial changes to established benchmarks and the addition of 
new benchmarks would be published for notice and comment in the Federal 
Register. The publication would indicate the amount of credit 
enhancement required for the type of securitization, and set forth 
other pool standards and restrictions. After considering any comments, 
the agencies would publish the revised benchmarks in the Federal 
Register.
    e. Implementation. The agencies may adopt all or part of this 
approach without reproposal, as modified based on comments, in the 
final rule issued in this rulemaking. In addition, if the agencies 
adopt this approach in the final rule, they may initially implement the 
approach on a smaller scale. For example, the approach may initially be 
limited to use with securitizations backed by residential mortgages, 
credit card or trade receivables. Non-traded positions in other types 
of securitizations would either have to qualify for some other approach 
adopted in the final rule or be subject to the full gross-up approach.
    f. Benchmarks. Following are draft initial ratings benchmarks for 
securitizations backed by residential mortgages, credit cards, 
automobile loans, trade receivables, and commercial real estate.

[[Page 59958]]



                                     Residential Mortgage-Backed Securities                                     
----------------------------------------------------------------------------------------------------------------
                                               ``Rating Benchmark'' prior credit                                
             Pool Type <SUP>1, <SUP>2                  enhancement required for ``A'' rating          Pool standards      
----------------------------------------------------------------------------------------------------------------
30-year loans...........................  1.6 percent...............................  Pools include at least 400
                                                                                       loans for each pool type.
15-year loans                             0.8 percent...............................  ..........................
Adjustable Rate Mortgages (ARMs) (1,5),   2.4 percent...............................  No borrower concentration 
 (2,6).                                                                                over 3 percent for each  
                                                                                       pool type.               
Hybrid loans (fixed-to-variable)........  2.4 percent...............................  ..........................
Balloon loans...........................  2.0 percent...............................  ..........................
                                          For no documentation and reduced                                      
                                           documentation loans, multiply the above                              
                                           enhancements by 2.                                                   
                                          For condominiums, two-to-four family, and                             
                                           cooperative apartments, multiply the                                 
                                           above enhancements by 2.                                             
                                          For B and C loans, multiply the above                                 
                                           enhancements by 3.                                                   
                                          For loan-to-value (LTV) ratios equal to or                            
                                           below 80 percent:                                                    
                                          --Use above enhancements..................                            
                                          --Multiply above enhancements by 2, if                                
                                           there is purchase mortgage insurance                                 
                                           (PMI) that brings loans below 80 percent.                            
                                          For LTV ratios above 80 percent, multiply                             
                                           the above enhancements by 4.                                         
                                          For the first five years of the                                       
                                           securitization, the above enhancement                                
                                           requirement, as a percentage of the                                  
                                           outstanding principal, remains fixed. For                            
                                           years six through ten, the enhancement                               
                                           requirement would be multiplied by 0.75.                             
                                           Beyond ten years, the enhancement would                              
                                           be multiplied by 0.5 <SUP>3, <SUP>4 .                                          
----------------------------------------------------------------------------------------------------------------
\1\ For positions that represent less than 10 percent of the size of the underlying pool of loans, add 20       
  percent to the enhancement level.                                                                             
\2\ For closed-end second mortgage securities, determine the LTV ratio of the loans in the security and apply   
  the enhancement requirements for the underlying collateral. In addition, change the 15-year enhancement       
  requirement to 1.6 percent due to increased risk of security.                                                 
\3\ The reduction in the multiplier over time reflects the reduced risk of the mortgage portfolio due to        
  seasoning.                                                                                                    
\4\ For a six-year old 15-year mortgage-backed security backed by B and C loans that have LTV ratios above 80   
  percent, the enhancement would be 0.8 percent x 3 x 4 x 0.75 = 7.2 percent.                                   


                                             Asset-Backed Securities                                            
----------------------------------------------------------------------------------------------------------------
                                               ``Rating Benchmark'' prior credit                                
              Pool Type \1\                  enhancement required for ``A'' rating          Pool standards      
----------------------------------------------------------------------------------------------------------------
Credit cards \2\........................  The higher of 6 percent or 1.2 times        Enhancement has access to 
                                           lagged charge-off rate \3\.                 excess spread.           
Auto Loans:.............................                                                                        
    Prime (A type)......................  7.0 percent...............................  Sellers of automobile     
                                                                                       loans must have at least 
                                                                                       three years of historical
                                                                                       information.             
    Sub-prime (B, C, and D types).......  The higher of 15.0 percent or 3 times net   Enhancement has access to 
                                           expected loss rate \4\.                     excess spread.           
Trade Receivables.......................  12.0 percent per loan pool \5\ (if all      Pools may not have seller 
                                           sellers of trade receivables are rated 1    concentrations above 5   
                                           or 2) 18.0 percent per loan pool \5\ (if    percent of pool amount.  
                                           any seller of trade receivables is rated                             
                                           3 or 4 and no lower than 4).                                         
                                          ..........................................  Based on Federal Reserve  
                                                                                       Board rating criteria for
                                                                                       trade receivables, each  
                                                                                       seller must be rated     
                                                                                       between 1 and 4.         
                                          The above enhancements will remain fixed    For credit cards and auto 
                                           as a percentage of outstanding principal,   loans, pool must be      
                                           with a floor of 3 percent of original       randomly selected and    
                                           principal.                                  nationally-diversified.  
----------------------------------------------------------------------------------------------------------------
\1\ For positions that represent less than 10 percent of the size of the underlying pool of loans, add 20       
  percent to the credit enhancement level.                                                                      
\2\ Credit cards include home equity lines of credit that are similar to credit card loans.                     
\3\ Lagged charge-off rate is based on the monthly average of past six month's charge-offs, multiplied by       
  twelve, then divided by the average outstanding balance from a year ago.                                      
\4\ Net expected loss rate is the monthly average of last quarter's gross default amount netted against         
  recoveries, multiplied by twelve, then divided by the average outstanding loan balance for the last quarter.  
\5\ Overcollateralization amount would count toward credit enhancement.                                         


                                      Commercial Mortgage-Backed Securities                                     
----------------------------------------------------------------------------------------------------------------
                                               ``Rating Benchmark'' prior credit                                
              Pool type \1\                  enhancement required for ``A'' rating          Pool standards      
----------------------------------------------------------------------------------------------------------------
Office..................................  26.0 percent..............................  Debt-service coverage at  
                                                                                       least 1.25               

[[Page 59959]]

                                                                                                                
Regional Mall...........................  10.0 percent..............................  Debt-service coverage at  
                                                                                       least 1.35               
Industrial/Anchored Retail..............  13.0 percent..............................  Debt-service coverage at  
                                                                                       least 1.35               
Multifamily.............................  17.0 percent..............................  Debt-service coverage at  
                                                                                       least 1.25               
                                          The above enhancements are for pools of     For each type of pool     
                                           loans with loan-to-value ratios less than   above:                   
                                           or equal to 70 percent. For pools of       --No borrower             
                                           loans with greater than 70 percent loan-    concentration over 5     
                                           to-value ratio, multiply the above          percent of pool amount.  
                                           enhancements by 1.5.                       --The amortization        
                                                                                       schedule does not exceed 
                                                                                       25 years.                
                                          For pools with property quality below the                             
                                           B level, multiply the above enhancements                             
                                           by 1.5.                                                              
                                          The above enhancements will remain fixed                              
                                           as a percentage of outstanding principal,                            
                                           with a floor of 3 percent of original                                
                                           principal \2\..                                                      
----------------------------------------------------------------------------------------------------------------
\1\ For positions that represent less than 10 percent of the underlying pool of loans, add 20 percent to the    
  credit enhancement level.                                                                                     
\2\ For example, the enhancement for a security containing regional mall loans with an 80 percent LTV ratio and 
  B quality property would be 10 percent x 1.5 x 1.5 = 22.5 percent.                                            

    g. Examples. To determine the dollar amount of prior credit 
enhancement required for a non-traded position of a securitization, the 
percentages shown in the benchmarks would be applied to the outstanding 
amount of the underlying loans in the securitization and monitored 
regularly by the regulatory agencies and by institutions. For example, 
for residential mortgage loans, the credit enhancement for a non-traded 
securitization position must be maintained at the outstanding principal 
level multiplied by 100 percent of the benchmark level for years one 
through five. For years six through ten, the required enhancement would 
be set at 75 percent of the benchmark level. For years eleven and 
beyond the enhancement requirement would be set at 50 percent of the 
benchmark level.<SUP>20</SUP>
---------------------------------------------------------------------------

    \20\ The reduction in the required credit enhancement amount 
over time is due to the reduced credit risk of seasoned mortgage 
loan pools.
---------------------------------------------------------------------------

    Example of a Residential Mortgage Securitization. Assume an 
institution has provided a 3 percent guarantee on a $6 million 
mezzanine position of a $200 million residential mortgage 
securitization. The junior position is a $10 million piece held by a 
second institution. The underlying mortgages are 15-year fixed-rate 
``B'' and ``C'' residential mortgage loans with no greater than 70 
percent loan-to-value ratios (LTV), with no private mortgage insurance. 
The benchmark requirement would be 0.8 percent (15-year mortgages) 
times 1 (70 percent LTV ratio) times 3 (``B'' and ``C'' loans) or 2.4 
percent of the securitization amount of $200 million, which equals $4.8 
million. Since the $10 million junior position exceeds $4.8 million, 
the guarantee would not be subject to the gross-up approach.
    After one year, losses on the pool are $2 million and the size of 
the pool decreases to $190 million. The benchmark requirement would be 
2.4 percent of $190 million or $4.5 million. Since the junior piece of 
$8 million still exceeds $4.5 million, the guarantee would still not be 
subject to the gross-up approach.
    Example of a Credit Card Securitization. Assume an institution has 
provided a guarantee for the bottom 15 percent of a $100 million credit 
card securitization. This bottom position is unrated. A third party 
provides a cash collateral account of 7 percent or $7 million in front 
of the unrated position. Because the pool is new, the institution must 
project the annual loss experience on the pool.<SUP>21</SUP> In this 
case, it projects 4 percent. Based on the benchmarks, the 4 percent 
should be multiplied by 1.2 and then compared with 6 percent to 
determine which of the two numbers is higher. Since 6 percent is 
higher, the benchmark requirement becomes 6 percent of $100 million or 
$6 million. Since the cash collateral account of $7 million exceeds 6 
percent of $100 million, the guarantee would receive a risk weight that 
is lower than under the gross-up approach.
---------------------------------------------------------------------------

    \21\ If the institution has experience with this type of pool, 
then this historical experience should be used to determine the loss 
rate required to determine the benchmark.
---------------------------------------------------------------------------

    After one year, the pool of credit card loans decreases to $80 
million. The experience on these credit card loans indicates that the 
lagged loss rate of the loans is 7 percent of the pool, not 4 percent 
as projected. In addition, assume the cash collateral account provided 
by the third party decreases to $5 million net of excess cash flows and 
pool losses. The benchmark is the higher of 6 percent or 8.4 percent 
(1.2 times 7 percent). The 8.4 percent benchmark is applied to the $80 
million pool resulting in a required enhancement of $6.7 million. Since 
this exceeds the $5 million cash collateral account, the gross-up 
approach would be applied to the guarantee. To avoid the fully-grossed-
up treatment, the third party would need to increase the cash 
collateral account by $1.7 million to $6.7 million.
    Example of a Trade Receivable Securitization. Assume an institution 
has provided a guarantee on the bottom 12 percent portion of an asset-
backed commercial paper program. All of the seller programs within the 
structure are rated 1 or 2 by the regulator. No program within the 
structure represents more than 5 percent of the pool and each program 
within the pool has 15 percent overcollateralization. The guarantee on 
this commercial paper program would not be grossed up because it is 
well-diversified, all programs are rated 1 or 2, and the over-
collateralization exceeds 12 percent.
    Assume that after six months, two of the pool's 
overcollateralization levels decrease to 10 percent and one of the 
seller programs is rated 3. The guarantee would be subject to the 
gross-up

[[Page 59960]]

approach for either of two reasons. First, none of the seller programs 
have 18 percent collateral, which is the new requirement based on the 
one program that is rated 3. Second, even if the one program was not 
rated 3, the two programs with 10 percent collateral do not meet the 12 
percent collateral requirement for 1- and 2-rated seller programs.
    (Question 9) What changes, if any, should be made to the amounts of 
prior credit enhancement and the pool standards required by the 
agencies' benchmarks? Please provide supporting information, if 
available.
    (Question 10) Can the benchmark standards be simplified without 
unduly relaxing the protection afforded to institutions by these 
standards?
    (Question 11) What additional types of pools and securitization 
transactions are sufficiently standardized and homogenous to permit the 
agencies to develop reliable benchmarks? Would it be reasonable to 
handle these securitizations on a case-by-case basis using the best 
available data from the rating agencies at the time of the 
securitization?
    (Question 12) Is the biennial review and update of the benchmarks 
appropriate?
    (Question 13) Please comment on ways the agencies could most 
effectively evaluate and monitor institutions' use of ratings 
benchmarks in the examination process with the least possible burden on 
institutions and examiners.
    (Question 14) Should the agencies adopt both the ratings-based 
approach and ratings benchmark approach for non-traded positions? 
Alternatively, should the agencies adopt only one of these approaches 
for non-traded positions in rated securitizations?
    (Question 15) If the agencies decide to adopt both approaches, 
should institutions be given the discretion to elect which of these 
approaches to use for their non-traded positions? On the other hand, if 
the agencies adopt the ratings benchmark approach, should the ratings-
based approach be used for non-traded positions in securitizations for 
which a benchmark has not been developed?
    (Question 16) Please compare the relative financial and operational 
burdens that would be imposed on institutions by the ratings-based 
approach and ratings benchmark approach for non-traded positions.
2. Internal Information Approaches
    In response to the 1994 Notice, the agencies also received several 
comments proposing approaches under which an institution would use 
credit information it has about the underlying assets to set the 
capital requirement for a position. These commenters observed that 
evaluating credit risks is a traditional area of bank expertise and 
that an institution knows its own assets better than anyone else.
    The agencies agree that using the information that institutions 
have about the credit quality of assets underlying a position could, if 
feasible, be more efficient than any of the ratings-based approaches 
for assessing capital requirements on non-traded positions. Therefore, 
the agencies are considering two approaches based on this type of 
information: the ``historical loss'' approach and the ``bank model'' 
approach. The agencies may adopt all or part of this historical loss 
approach in the final rule adopted in this rulemaking without 
reproposal. Accordingly, the agencies solicit comments and supporting 
information to aid in their development of the historical loss and bank 
model approaches.
    a. Historical Loss Approach. A principal purpose of regulatory 
capital is to provide a cushion against unexpected losses. The 
historical loss approach being considered by the agencies would take 
unexpected losses over the life of the asset pool into account. These 
losses may not be taken into account fully in the ratings-based 
approaches. The historical loss approach, however, bases the risk-based 
capital treatment for a position in a securitization on the 
characteristics of the underlying pool of assets, including the 
variance of losses. This variance is the source of unexpected losses. 
While the historical loss approach could, in theory, be used for all 
recourse obligations and direct credit substitutes, the agencies are 
proposing that the approach initially be applied only to non-traded 
positions in securitizations with at least one traded position.
    To measure the variance of losses on a pool of assets, an 
institution would have to project the probability distribution of the 
cumulative losses on the underlying assets over the life of the pool 
based on historical loss information for assets comparable to those in 
the pool. Comparability would encompass such factors as credit quality, 
collateral, and repayment terms. The cumulative losses would be the 
portion of the assets in the pool that would not be recovered over the 
life of the pool.
    Under this approach, the risk-based capital treatment for a non-
traded position would depend on the expected value of losses on the 
underlying pool, plus a specified number of standard deviations. As a 
general rule, at the inception of a securitization, the holder or 
issuer of a non-traded position would determine whether the holder 
would incur a loss if the cumulative losses on the underlying assets in 
the pool reached the expected value of losses plus the designated 
number of standard deviations (e.g., expected loss plus five standard 
deviations for normal distributions). This determination would consider 
any available qualifying credit enhancements providing support to the 
position and the existence of any more junior positions in the 
securitization.
    Thus, the expected value of losses plus the designated number of 
standard deviations would serve as a boundary. If the holder of a non-
traded position would suffer a loss when the level of cumulative losses 
on the underlying assets in the pool reached this boundary, then the 
position would receive the gross-up treatment. The institution's 
capital requirement, however, would be subject to the low-level rule. 
Otherwise, the position would qualify to be treated in the same manner 
as traded positions with ratings below ``AAA'' under the multi-level, 
ratings-based approach. In short, the non-traded position would qualify 
to use either the face value treatment or the ``modified gross-up'' 
approach, depending upon which of these proposed alternatives the 
agencies adopt in their final rules (see sections II.C and II.D of this 
preamble). An institution's estimate of the probability distribution, 
measurement of the variance, assessment of the support provided by 
credit enhancements, and determination of the loss exposure on a non-
traded position, as well as the resulting risk-based capital treatment 
of the position, would be subject to review by examiners.
    In projecting the probability distribution of the losses on a 
pool's underlying assets, an institution would need to compile and 
analyze historical loss information for individual assets that are 
comparable to those in the pool. This would include considering the 
size of the losses on individual assets and, depending on the type of 
credit enhancement supporting the securitization, the amount of time 
after the origination of the type of assets being securitized when 
losses generally occur on that asset type. This information may be 
available from the information the issuer supplies to the rating 
agencies for their use in rating the securitization's traded positions.
    The agencies are proposing that the types of credit enhancement 
that would qualify to be considered when determining whether the holder 
of a

[[Page 59961]]

non-traded position would incur any losses be the same as those 
proposed under the ratings benchmark approach. The size or availability 
of one or more of the credit enhancements in a securitization (e.g., a 
spread account), however, may vary over time based on the performance 
of the pool's underlying assets. If such a credit enhancement supports 
one or more of the positions in a securitization, the institution also 
would need to consider the shape of the loss curve over the life of the 
pool that produces cumulative losses over that period equal to the 
expected value of losses, plus the designated number of standard 
deviations. In this situation, as a supplement to the general rule 
cited previously, the size of the credit enhancement that would be 
available at any point over the life of the pool given the loss curve's 
indicated level of losses would need to be sufficient to prevent the 
holder of a non-traded position from suffering a loss in order for the 
non-traded position to avoid application of the gross-up approach.
    As an example of the application of this historical loss approach, 
assume an institution owns a non-traded $100 subordinated piece of a 
$1,000 securitized asset pool. A qualifying standby letter of credit 
issued by a bank will absorb the first $20 of losses for the pool, 
thereby providing partial protection to the institution's subordinated 
position. For asset pools of this type, the institution determines that 
the expected value of losses plus the designated number of standard 
deviations over the life of the pool is $80. Given the size of the 
credit enhancement, the institution will sustain a loss of $60 on its 
subordinated interest if pool losses reach the expected value of 
losses, plus the designated number of standard deviations. Therefore, 
the institution's position would be subject to the gross-up approach. 
Capital would be held for the institution's position plus all more 
senior positions. After considering the $20 qualifying standby letter 
of credit (which would be treated as a bank guarantee on part of the 
pool) and assuming the assets in the pool are risk-weighted at 100 
percent, the risk-based capital charge for the subordinated piece would 
be $78.72 [($20 x 20 percent x 8 percent) + ($980 x 100 percent x 8 
percent)].
    In contrast, if the expected value of losses plus the designated 
number of standard deviations over the life of the pool in the 
preceding example were only $19, the $20 credit enhancement would fully 
absorb those losses and the institution would not expect to incur any 
losses on its subordinated position. The institution's position would 
qualify for the capital treatment applicable to traded investment-grade 
positions rated below ``AAA.''
    Based on discussions with market participants, the agencies believe 
that those institutions that are active in the securitization business 
will normally possess historical loss data for assets comparable to 
those they are securitizing. In this regard, these institutions must be 
capable of measuring and monitoring the credit risk they have retained 
or assumed in securitizations to conduct their securitization 
activities in a safe and sound manner. If an institution were unable to 
do the statistical analysis necessary to implement this proposed 
historical loss approach, however, its non-traded positions would be 
subject to the gross-up approach.
    (Question 17) Given the varying number of years in the life of a 
pool for different types of assets, what is the minimum number of years 
of historical loss data that should be used to project the probability 
distribution of the cumulative losses on each type of underlying asset 
pool over the pool's life? If information for the minimum number of 
years is not available, is it reasonable for institutions to be 
required to apply the gross-up approach to non-traded positions?
    (Question 18) How should institutions determine whether the capital 
requirement for a non-traded position should be changed over time? 
Should institutions periodically adjust the loss distribution that they 
used to set their initial capital requirement to reflect actual losses 
on pool assets over the life of the pool?
    (Question 19) Is it reasonable for the agencies to use a log normal 
curve to describe the distribution of losses on a pool of assets? Would 
another approach be preferable and, if so, why would it be preferable?
    (Question 20) Would this approach be applicable to all asset types 
or are there some asset types with unusual characteristics for which 
this approach would be inappropriate?
    (Question 21) How burdensome would this historical loss approach be 
for institutions? To what extent is the necessary loss data available? 
What modifications should the agencies consider making as they develop 
this approach?
    b. Bank Model Approach. Commenters on the 1994 Notice suggested 
that the capital requirements for recourse obligations and direct 
credit substitutes also could be based on internal risk assessments 
made by banks holding those positions. Over the past decade, some 
banking organizations have developed, for their own internal risk 
management purposes, statistical techniques for quantifying the credit 
risk in sub-portfolios of credit instruments such as direct credit 
substitutes. In principle, these ``internal models'' for measuring 
credit risk could be used in setting capital requirements for direct 
credit substitutes and possibly other credit positions. Such a system 
would be broadly consistent with both the internal models approach to 
capital now being implemented for market risks associated with bank 
trading activities, as well as with current supervisory policies for 
evaluating the adequacy of the allowance for loan and lease losses.
    Currently, the agencies are uncertain whether an internal model 
approach is feasible. However, the agencies recognize that the 
development of an internal model approach to capital for direct credit 
substitutes, and perhaps for other credit instruments, could have 
significant benefits. For example, under the ratings approach, a bank's 
internal risk assessment--if acceptable to supervisors--might 
substitute for a credit rating, thus reducing costs and delays 
associated with obtaining credit ratings. Alternatively, an acceptable 
internal model for measuring credit risk might form the basis for 
assessing capital requirements on a portfolio basis rather than on an 
asset-by-asset basis, thus better reflecting a bank's diversification 
and hedging activities.
    The agencies note that securitization activities can create 
positions that add significantly to the volatility, appropriately 
measured, of an institution's credit losses. Banks for which such 
activities are significant should have in place appropriate policies 
and practices to quantify and manage the credit risk associated with 
securitization. The agencies, as always, will review the quality of 
such policies and practices within the context of evaluating the 
overall quality of a bank's risk management processes.
    (Question 22) Is an internal model approach to setting capital 
requirements for recourse, direct credit substitutes, and other credit 
instruments currently feasible and, if so, how might it be structured?
    (Question 23) Which types of credit activities would be amenable to 
such an approach?
    (Question 24) How could the agencies validate such internal models 
and their credit risk assessments?

III. Regulatory Flexibility Act

    OCC: Pursuant to section 605(b) of the Regulatory Flexibility Act, 
the OCC

[[Page 59962]]

certifies that this proposal will not have a significant impact on a 
substantial number of small entities. 5 U.S.C. 601 et seq. The 
provisions of this proposal that increase capital requirements are 
likely to affect large banks almost exclusively. (Small banks are 
unlikely to be in a position to provide direct credit substitutes in 
asset securitizations.) Accordingly, a regulatory flexibility analysis 
is not required.
    Board: Pursuant to section 605(b) of the Regulatory Flexibility 
Act, the Board does not believe this proposal will have a significant 
impact on a substantial number of small business entities in accord 
with the spirit and purposes of the Regulatory Flexibility Act (5 
U.S.C. 601 et seq.). The Board's comparison of the applicability 
section of this proposal with Call Report Data on all existing banks 
shows that application of the rule to small entities will be the rare 
exception. Accordingly, a regulatory flexibility analysis is not 
required. In addition, because the risk-based capital standards 
generally do not apply to bank holding companies with consolidated 
assets of less than $150 million, this rule will not affect such 
companies.
    FDIC: Pursuant to section 605(b) of the Regulatory Flexibility Act 
(Pub. L. 96-354, 5 U.S.C. 601 et seq.), the FDIC certifies that the 
proposed rule will not have a significant impact on a substantial 
number of small entities. Comparison of Call Report data on FDIC-
supervised banks to the items covered by the proposal that result in 
increased capital requirements shows that application of the rule to 
small entities will be the infrequent exception.
    OTS: Pursuant to section 605(b) of the Regulatory Flexibility Act, 
the OTS certifies that this proposal will not have a significant impact 
on a substantial number of small entities. The proposal is likely to 
reduce slightly the risk-based capital requirements for recourse 
obligations and direct credit substitutes, except for some standby 
letters of credit. Thrifts currently issue few, if any, standby letters 
of credit. Accordingly, a regulatory flexibility analysis is not 
required.

IV. Paperwork Reduction Act

    Board: In accordance with the Paperwork Reduction Act of 1995 (44 
U.S.C. Ch. 3506; 5 CFR 1320 Appendix A.1), the Board reviewed the 
proposed rule under the authority delegated to the Board by the Office 
of Management and Budget. No collections of information pursuant to the 
Paperwork Reduction Act are contained in the proposed rule.

V. Executive Order 12866

    OCC: On the basis of the best information available, the OCC has 
determined that this proposal is not a significant regulatory action 
for purposes of Executive Order 12866. However, the impact of any final 
rule resulting from this proposal will depend on factors for which the 
agencies do not currently collect industry-wide information, such as 
the proportion of bank-provided direct credit substitutes that would be 
rated below investment grade. The OCC therefore welcomes any 
quantitative information national banks wish to provide about the 
impact they expect the various portions of this proposal to have if 
issued in final form.
    OTS: The Director of the OTS has determined that this proposal does 
not constitute a ``significant regulatory action'' under Executive 
Order 12866. The proposal is likely to reduce slightly the risk-based 
capital requirements for recourse obligations and direct credit 
substitutes, except for some standby letters of credit. Thrifts 
currently issue few, if any, standby letters of credit. As a result, 
the OTS has concluded that the proposal will have only minor effects on 
the thrift industry.

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

    Section 202 of the Unfunded Mandates Reform Act of 1995 (Unfunded 
Mandates Act), requires that an agency prepare a budgetary impact 
statement before promulgating a rule that includes a Federal mandate 
that may result in the expenditure by state, local, and tribal 
governments, in the aggregate, or by the private sector, of $100 
million or more in any one year. If a budgetary impact statement is 
required, section 205 of the Unfunded Mandates Act also requires an 
agency to identify and consider a reasonable number of regulatory 
alternatives before promulgating a rule. The OCC and OTS have 
determined that this proposal will not result in expenditures by state, 
local, and tribal governments, or by the private sector, of more than 
$100 million or more in any one year. Therefore, the OCC and OTS have 
not prepared a budgetary impact statement or specifically addressed the 
regulatory alternatives considered. As discussed in the preamble, this 
proposal rule will correct certain inconsistencies in the agencies' 
risk-based capital standards and will allow banking organizations to 
maintain lower amounts of capital against certain rated recourse 
obligations and direct credit substitutes.

List of Subjects

12 CFR Part 3

    Administrative practice and procedure, Capital, National banks, 
Reporting and recordkeeping requirements, Risk.

12 CFR Part 208

    Accounting, Agriculture, Banks, banking, Confidential business 
information, Crime, Currency, Federal Reserve System, Mortgages, 
Reporting and recordkeeping requirements, Securities.

12 CFR Part 225

    Administrative practice and procedure, Banks, banking, Federal 
Reserve System, Holding companies, Reporting and recordkeeping 
requirements, Securities.

12 CFR Part 325

    Administrative practice and procedure, Banks, banking, Capital 
adequacy, Reporting and recordkeeping requirements, Savings 
associations, State non-member banks.

12 CFR Part 567

    Capital, Reporting and recordkeeping requirements, Savings 
associations.

Office of the Comptroller of the Currency

12 CFR Chapter I

Authority and Issuance

    For the reasons set out in the preamble, appendix A of part 3 of 
chapter I of title 12 of the Code of Federal Regulations is proposed to 
be amended as follows:

PART 3--MINIMUM CAPITAL RATIOS; ISSUANCE OF DIRECTIVES

    1. The authority citation for part 3 continues to read as follows:

    Authority: 12 U.S.C. 93a, 161, 1818, 1828(n), 1828 note, 1831n 
note, 1835, 3907 and 3909.

    2. In part 3, appendix A, section 3, paragraph (b) is amended by 
adding a new sentence at the end of the introductory text; paragraph 
(b)(1)(i) and footnote 13 are removed and reserved; paragraph 
(b)(1)(ii) is revised; paragraph (b)(1)(iii) and footnote 14 are 
removed and reserved; footnote 16 in paragraph (b)(2)(i) and footnote 
17 in paragraph (b)(2)(ii) are revised; and paragraph (d) is revised to 
read as follows:

Appendix A to Part 3--Risk-Based Capital Guidelines

* * * * *

[[Page 59963]]

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

* * * * *
    (b) * * * However, direct credit substitutes, recourse 
obligations, and securities issued in connection with asset 
securitizations are treated as described in section 3(d) of this 
appendix A.
    (1) * * *
    (ii) Risk participations purchased in bankers' acceptances.
* * * * *
    (2) * * *
    (i) * * * <SUP>16</SUP>* * *
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    \16\ Participations in performance-based standby letters of 
credit are treated in accordance with section 3(d) of this appendix 
A.
---------------------------------------------------------------------------

    (ii) * * * <SUP>17</SUP>* * *
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    \17\ Participations in commitments are treated in accordance 
with section 3(d) of this appendix A.
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* * * * *
    (d) Recourse obligations, direct credit substitutes, and asset- 
and mortgage-backed securities. (1) Definitions. For purposes of 
this section 3 of this appendix A:
    (i) Direct credit substitute means an arrangement in which a 
national bank assumes, in form or in substance, any risk of credit 
loss directly or indirectly associated with a third-party asset or 
other financial claim, that exceeds the national bank's pro rata 
share of the asset or claim. If a national bank has no claim on the 
asset, then the assumption of any risk of credit loss is a direct 
credit substitute. Direct credit substitutes include, but are not 
limited to:
    (A) Financial guarantee-type standby letters of credit that 
support financial claims on the account party;
    (B) Guarantees, surety arrangements, and irrevocable guarantee-
type instruments backing financial claims;
    (C) Purchased subordinated interests or securities that absorb 
more than their pro rata share of losses from the underlying assets;
    (D) Loans or lines of credit that provide credit enhancement for 
the financial obligations of an account party; and
    (E) Purchased loan servicing assets if the servicer is 
responsible for credit losses associated with the loans being 
serviced (other than servicer cash advances as defined in section 
3(d)(1)(v) of this appendix A), or if the servicer makes or assumes 
representations and warranties on the loans (other than standard 
representations and warranties as defined in section 3(d)(1)(vi) of 
this appendix A).
    (ii) Financial guarantee-type standby letter of credit means any 
letter of credit or similar arrangement, however named or described, 
which represents an irrevocable obligation to the beneficiary on the 
part of the issuer:
    (A) To repay money borrowed by, or advanced to, or for the 
account of, an account party; or
    (B) To make payment on account of any indebtedness undertaken by 
an account party, in the event that the account party fails to 
fulfill its obligation to the beneficiary.
    (iii) Rated means, with respect to an instrument or obligation, 
that the instrument or obligation has received a credit rating from 
a nationally-recognized statistical rating organization. An 
instrument or obligation is rated investment grade if it has 
received a credit rating that falls within one of the four highest 
rating categories used by the nationally-recognized statistical 
rating organization. An instrument or obligation is rated in the 
highest investment grade category if it has received a credit rating 
that falls within the highest investment grade category used by the 
nationally-recognized statistical rating organization.
    (iv) Recourse means the retention in form or substance of any 
risk of credit loss directly or indirectly associated with a 
transferred asset that exceeds a pro rata share of a national bank's 
claim on the asset. If a national bank has no claim on a transferred 
asset, then the retention of any risk of credit loss is recourse. A 
recourse obligation typically arises when an institution transfers 
assets and retains an obligation to repurchase the assets or to 
absorb losses due to a default of principal or interest or any other 
deficiency in the performance of the underlying obligor or some 
other party. Recourse may exist implicitly where a bank provides 
credit enhancement beyond any contractual obligation to support 
assets it has sold. Recourse obligations include, but are not 
limited to:
    (A) Representations and warranties on the transferred assets 
(other than standard representations and warranties as defined in 
section 3(d)(1)(vi) of this appendix A);
    (B) Retained loan servicing assets if the servicer is 
responsible for losses associated with the loans serviced (other 
than a servicer cash advance as defined in section 3(d)(1)(v) of 
this appendix A);
    (C) Retained subordinated interests or securities that absorb 
more than their pro rata share of losses from the underlying assets;
    (D) Assets sold under an agreement to repurchase; and
    (E) Loan strips sold without direct recourse where the maturity 
of the transferred loan is shorter than the maturity of the 
commitment.
    (v) Servicer cash advance means funds that a residential 
mortgage loan servicer advances to ensure an uninterrupted flow of 
payments or the timely collection of residential mortgage loans, 
including disbursements made to cover foreclosure costs or other 
expenses arising from a mortgage loan to facilitate its timely 
collection. A servicer cash advance is not a recourse obligation or 
a direct credit substitute if:
    (A) The mortgage servicer is entitled to full reimbursement; or
    (B) For any one mortgage loan, nonreimbursable advances are 
contractually limited to an insignificant amount of the outstanding 
principal on that loan.
    (vi) Standard representations and warranties means contractual 
provisions that a national bank extends when it transfers assets 
(including loan servicing assets), or assumes when it purchases loan 
servicing assets. To qualify as a standard representation or 
warranty, a contractual provision must:
    (A) Refer to facts that the seller or servicer can verify, and 
has verified with reasonable due diligence, prior to the time that 
assets are transferred (or servicing assets are acquired);
    (B) Refer to a condition that is within the control of the 
seller or servicer; or
    (C) Provide for the return of assets in the event of fraud or 
documentation deficiencies.
    (vii) Traded position means a recourse obligation, direct credit 
substitute, or asset- or mortgage-backed security that is retained, 
assumed, or issued in connection with an asset securitization and 
that was rated with a reasonable expectation that, in the near 
future:
    (A) The position would be sold to investors relying on the 
rating; or
    (B) A third party would, in reliance on the rating, enter into a 
transaction such as a purchase, loan or repurchase agreement 
involving the position.
    (2) Risk-weighted asset amount. Except as otherwise provided in 
sections 3(d)(3) and (4) of this appendix A, to calculate the risk-
weighted asset amount for a recourse obligation or direct credit 
substitute, multiply the amount of assets from which risk of credit 
loss is directly or indirectly retained or assumed, by the 
appropriate risk weight using the criteria regarding obligors, 
guarantors, and collateral listed in section 3(a) of this appendix 
A. For purposes of this section 3(d) of this appendix A, the amount 
of assets from which risk of credit loss is directly or indirectly 
retained or assumed means:
    (i) For a financial guarantee-type standby letter of credit, 
surety arrangement, guarantee, or irrevocable guarantee-type 
instrument, the amount of the assets that the direct credit 
substitute fully or partially supports;
    (ii) For a subordinated interest or security, the amount of the 
subordinated interest or security plus all more senior interests or 
securities;
    (iii) For mortgage servicing rights that are recourse 
obligations or direct credit substitutes, the outstanding amount of 
the loans serviced;
    (iv) For representations and warranties (other than standard 
representations and warranties), the amount of the assets subject to 
the representations or warranties;
    (v) For loans on lines of credit that provide credit enhancement 
for the financial obligations of an account party, the amount of the 
enhanced financial obligations;
    (vi) For loans strips, the amount of the loans; and
    (vii) For assets sold with recourse, the amount of assets from 
which risk of credit loss is directly or indirectly retained or 
assumed, less any applicable recourse liability account established 
in accordance with generally accepted accounting principles.
    (3) Investment grade recourse obligations, direct credit 
substitutes, and asset-and mortgage-backed securities. (i) 
Eligibility. A traded position is eligible for the treatment 
described in this section 3(d)(3) of this appendix A if it has been 
rated investment grade by a nationally-recognized statistical rating 
organization. A recourse obligation or direct credit substitute that 
is not a traded position is eligible for the treatment described in 
this section 3(d)(3) of this

[[Page 59964]]

appendix A if it has been rated investment grade by two nationally-
recognized statistical rating organizations, the ratings are 
publicly available, the ratings are based on the same criteria used 
to rate securities sold to the public, and the recourse obligation 
or direct credit substitute provide credit enhancement to a 
securitization in which at least one position is traded.
    (ii) Highest investment grade. To calculate the risk-weighted 
asset amount for a recourse obligation, direct credit substitute, or 
asset-or mortgage-backed security that is rated in the highest 
investment grade category, multiply the face amount of the position 
by a risk weight of 20 percent.
    (iii) Other investment grade.
    [Option 1--Face Value Treatment] To calculate the risk-weighted 
asset amount for a recourse obligation, direct credit substitute, or 
asset- or mortgage-backed security that is rated investment grade, 
multiply the face amount of the position by a risk weight of 100 
percent.
    [Option 2--Modified Gross-Up] To calculate the risk-weighted 
asset amount for a recourse obligation, direct credit substitute, or 
asset- or mortgage-backed security that is rated investment grade, 
multiply the amount of assets from which risk of credit loss is 
directly or indirectly retained or assumed by a risk weight of 50 
percent.
    (4) Participations. The risk-weighted asset amount for a 
participation interest in a direct credit substitute is calculated 
as follows:
    (i) Determine the risk-weighted asset amount for the direct 
credit substitute as if the bank held all of the interests in the 
participation.
    (ii) Multiply the risk-weighted asset amount determined under 
section 3(d)(4)(i) of this appendix A by the percentage of the 
bank's participation interest.
    (iii) If the bank is exposed to more than its pro rata share of 
the risk of credit loss on the direct credit substitute (e.g., the 
bank remains secondarily liable on participations held by others), 
add to the amount computed under section 3(d)(4)(ii) of this 
appendix A an amount computed as follows: multiply the amount of the 
direct credit substitute by the percentage of the direct credit 
substitute held by others and then multiply the result by the lesser 
of the risk-weight appropriate for the holders of those interests or 
the risk weight appropriate for the direct credit substitute.
    (5) Limitations on risk-based capital requirements. (i) Low-
level recourse. If the maximum contractual liability or exposure to 
credit loss retained or assumed by a bank in connection with a 
recourse obligation or a direct credit substitute is less than the 
effective risk-based capital requirement for the enhanced assets, 
the risk-based capital requirement is limited to the maximum 
contractual liability or exposure to loss, less any recourse 
liability account established in accordance with generally accepted 
accounting principles. This limitation does not apply to assets sold 
with implicit recourse.
    (ii) Mortgage-related securities or participation certificates 
retained in a mortgage loan swap. If a bank holds a mortgage-related 
security or a participation certificate as a result of a mortgage 
loan swap with recourse, capital is required to support the recourse 
obligation plus the percentage of the mortgage-related security or 
participation certificate that is not protected against risk of loss 
by the recourse obligation. The total amount of capital required for 
the on-balance sheet asset and the recourse obligation, however, is 
limited to the capital requirement for the underlying loans, 
calculated as if the bank continued to hold these loans as an on-
balance sheet asset.
    (iii) Related on-balance sheet assets. To the extent that an 
asset is included in the calculation of the risk-based capital 
requirement under this section 3(d) of this appendix A and may also 
be included as an on-balance sheet asset, the asset is risk-weighted 
only under this section 3(d) of this appendix A except that mortgage 
servicing assets and similar arrangements with embedded recourse 
obligations or direct credit substitutes are risk-weighted as on-
balance sheet assets and related recourse obligations and direct 
credit substitutes are risk-weighted under this section 3(d) of this 
appendix A.
* * * * *
    3. In appendix A, Table 2, item 1 under ``100 Percent Conversion 
Factor'' is revised to read as follows:
* * * * *

Table 2--Credit Conversion Factors For Off-Balance Sheet Items

100 Percent Conversion Factor

    1. [Reserved]
* * * * *
    Dated: October 22, 1997.
Eugene A. Ludwig,
Comptroller of the Currency.

Federal Reserve System

12 CFR Chapter II

    For the reasons set forth in the joint preamble, parts 208 and 225 
of chapter II of title 12 of the Code of Federal Regulations are 
proposed to be amended as follows:

PART 208--MEMBERSHIP OF STATE BANKING INSTITUTIONS IN THE FEDERAL 
RESERVE SYSTEM (REGULATION H)

    1. The authority citation for part 208 continues to read as 
follows:

    Authority: 12 U.S.C. 24, 36, 92a, 93a, 248(a), 248(c), 321-338a, 
371d, 461, 481-486, 601, 611, 1814, 1816, 1818, 1820(d)(9), 1823(j), 
1828(o), 1831o, 1831p-1,1831 r-1, 1835a, 1882, 2901-2907, 3105, 
3310, 3331-3351, and 3906-3909; 15 U.S.C. 78b, 78l(b), 78l(g), 
78l(i), 78o-4(c)(5), 78q, 78q-1, and 78w; 31 U.S.C. 5318; 42 U.S.C. 
4012a, 4104a, 4104b, 4106, and 4128.

    2. In appendix A to part 208, section III.B. is amended by revising 
paragraph 3. and in paragraph 4., footnote 24 is redesignated as 
footnote 28. The revision reads as follows:

Appendix A to Part 208--Capital Adequacy Guidelines for State Member 
Banks: Risk-Based Measure

* * * * *
    III. * * *
    B. * * *
    3. Recourse obligations, direct credit substitutes, and asset -
and mortgage-backed securities. Direct credit substitutes, assets 
transferred with recourse, and securities issued in connection with 
asset securitizations are treated as described below.
    (a) Definitions-- (1) Direct credit substitute means an 
arrangement in which a bank assumes, in form or in substance, any 
risk of credit loss directly or indirectly associated with a third-
party asset or other financial claim, that exceeds the bank's pro 
rata share of the asset or claim. If the bank has no claim on the 
asset, then the assumption of any risk of loss is a direct credit 
substitute. Direct credit substitutes include, but are not limited 
to:
    (i) Financial guarantee-type standby letters of credit that 
support financial claims on the account party;
    (ii) Guarantees, surety arrangements, and irrevocable guarantee-
type instruments backing financial claims such as outstanding 
securities, loans, or other financial liabilities, or that back off-
balance-sheet items against which risk-based capital must be 
maintained;
    (iii) Purchased subordinated interests or securities that absorb 
more than their pro rata share of losses from the underlying assets;
    (iv) Loans or lines of credit that provide credit enhancement 
for the financial obligations of an account party; and
    (v) Purchased loan servicing assets if the servicer is 
responsible for credit losses associated with the loans being 
serviced (other than mortgage servicer cash advances as defined in 
paragraph III.B.3.(a)(3) of this appendix A), or if the servicer 
makes or assumes representations and warranties on the loans other 
than standard representations and warranties as defined in paragraph 
III.B.3.(a)(6) of this appendix A.
    (2) Financial guarantee-type standby letter of credit means any 
letter of credit or similar arrangement, however named or described, 
that represents an irrevocable obligation to the beneficiary on the 
part of the issuer:
    (i) To repay money borrowed by, advanced to, or for the account 
of, the account party; or
    (ii) To make payment on account of any indebtedness undertaken 
by the account party in the event that the account party fails to 
fulfill its obligation to the beneficiary.
    (3) Mortgage servicer cash advance means funds that a 
residential mortgage loan servicer advances to ensure an 
uninterrupted flow of payments or the timely collection of 
residential mortgage loans, including disbursements made to cover 
foreclosure costs or other expenses arising from a mortgage loan to 
facilitate its timely collection. A servicer cash advance is not a 
recourse obligation or a direct credit substitute if the mortgage 
servicer is entitled to full reimbursement or, for any one 
residential mortgage loan, nonreimbursable

[[Page 59965]]

advances are contractually limited to an insignificant amount of the 
outstanding principal on that loan.
    (4) Rated means, with respect to an instrument or obligation, 
that the instrument or obligation has received a credit rating from 
a nationally-recognized statistical rating organization. An 
instrument or obligation is rated investment grade if it has 
received a credit rating that falls within one of the four highest 
rating categories used by the organization, e.g., at least BBB or 
its equivalent. An instrument or obligation is rated in the highest 
investment grade if it has received a credit rating that falls 
within the highest rating category used by the organization.
    (5) Recourse means an arrangement in which a bank retains, in 
form or in substance, any risk of credit loss directly or indirectly 
associated with a transferred asset that exceeds a pro rata share of 
the bank's claim on the asset. If a bank has no claim on a 
transferred asset, then the retention of any risk of loss is 
recourse. A recourse obligation typically arises when an institution 
transfers assets and retains an obligation to repurchase the assets 
or absorb losses due to a default of principal or interest or any 
other deficiency in the performance of the underlying obligor or 
some other party. Recourse may exist implicitly where a bank 
provides credit enhancement beyond any contractual obligation to 
support assets it has sold. Recourse obligations include, but are 
not limited to:
    (i) Representations and warranties on the transferred assets 
other than standard representations and warranties as defined in 
paragraph III.B.3.(a)(6) of this appendix A;
    (ii) Retained loan servicing assets if the servicer is 
responsible for losses associated with the loans being serviced 
other than mortgage servicer cash advances as defined in paragraph 
III.B.3.(a)(3) of this appendix A;
    (iii) Retained subordinated interests or securities that absorb 
more than their pro rata share of losses from the underlying assets;
    (iv) Assets sold under an agreement to repurchase; and
    (v) Loan strips sold without direct recourse where the maturity 
of the transferred loan that is drawn is shorter than the maturity 
of the commitment.
    (6) Standard representations and warranties means contractual 
provisions that a bank extends when it transfers assets (including 
loan servicing assets) or assumes when it purchases loan servicing 
assets. To qualify as a standard representation or warranty, a 
contractual provision must:
    (i) Refer to facts that the seller or servicer can verify, and 
has verified with reasonable due diligence, prior to the time that 
assets are transferred (or servicing assets are acquired);
    (ii) Refer to a condition that is within the control of the 
seller or servicer; or
    (iii) Provide for the return of assets in the event of fraud or 
documentation deficiencies.
    (7) Traded position means a recourse obligation, direct credit 
substitute, or asset- or mortgage-backed security that is retained, 
assumed, or issued in connection with an asset securitization and 
that is rated with a reasonable expectation that, in the near 
future:
    (i) The position would be sold to investors relying on the 
rating; or
    (ii) A third party would, in reliance on the rating, enter into 
a transaction such as a purchase, loan, or repurchase agreement 
involving the position.
    (b) Amount of position to be included in risk-weighted assets--
(1) Determining the credit equivalent amount of recourse obligations 
and direct credit substitutes. The credit equivalent amount for a 
recourse obligation or direct credit substitute (except as otherwise 
provided in paragraph III.B.3.(b)(2) of this appendix A) is the full 
amount of the credit enhanced assets from which risk of credit loss 
is directly or indirectly retained or assumed. This credit 
equivalent amount is assigned to the risk weight appropriate to the 
obligor, or if relevant, the guarantor or nature of any collateral. 
Thus, a bank that extends a partial direct credit substitute, e.g., 
a standby letter of credit that absorbs the first 10 percent of loss 
on a transaction, must maintain capital against the full amount of 
the assets being supported. Furthermore, for direct credit 
substitutes that are on-balance sheet, e.g., purchased subordinated 
securities, banks must maintain capital against the amount of the 
direct credit substitutes and the full amounts of the assets being 
supported, i.e., all more senior positions. This treatment is 
subject to the low-level recourse rule discussed in section 
III.B.3.(c)(1) of this appendix A. For purposes of this appendix A, 
the full amount of the credit enhanced assets from which risk of 
credit loss is directly or indirectly retained or assumed means for:
    (i) A financial guarantee-type standby letter of credit, surety 
arrangement, guarantee, or irrevocable guarantee-type instruments, 
the full amount of the assets that the direct credit substitute 
fully or partially supports;
    (ii) A subordinated interest or security, the amount of the 
subordinated interest or security plus all more senior interests or 
securities;
    (iii) Mortgage servicing assets that are recourse obligations or 
direct credit substitutes, the outstanding amount of the loans 
serviced;
    (iv) Representations and warranties (other than standard 
representations and warranties), the amount of the assets subject to 
the representations or warranties;
    (v) Loans or lines of credit that provide credit enhancement for 
the financial obligations of an account party, the full amount of 
the enhanced financial obligations;
    (vi) Loans strips, the amount of the loans;
    (vii) For assets sold with recourse, the amount of assets from 
which risk of loss is directly or indirectly retained, less any 
applicable recourse liability account established in accordance with 
generally accepted accounting principles; and
    (viii) Other types of recourse obligations or direct credit 
substitutes should be treated in accordance with the principles 
contained in section III.B.3. of this appendix A.
    (2) Determining the credit risk weight of investment grade 
recourse obligations, direct credit substitutes, and asset- and 
mortgage-backed securities. A traded position is eligible for the 
risk-based capital treatment described in this paragraph if it has 
been rated at least investment grade by a nationally-recognized 
statistical rating organization. A recourse obligation or direct 
credit substitute that is not a traded position is eligible for the 
treatment described in this paragraph if it has been rated at least 
investment grade by two nationally-recognized statistical rating 
organizations, the ratings are publicly available, the ratings are 
based on the same criteria used to rate securities sold to the 
public, and the recourse obligation or direct credit substitute 
provides credit enhancement to a securitization in which at least 
one position is traded.
    (i) Highest investment grade. Except as otherwise provided in 
this section III. of this appendix A, the face amount of a recourse 
obligation, direct credit substitute, or an asset- or mortgage-
backed security that is rated in the highest investment grade 
category is assigned to the 20 percent risk category.
    (ii) Other investment grade. [Option 1--Face Value Treatment] 
Except as otherwise provided in this section III. of this appendix 
A, the face amount of a recourse obligation, direct credit 
substitute, or an asset- or mortgage-backed security that is rated 
investment grade is assigned to the 100 percent risk category.
    [Option 2--Modified Gross-Up] Except as otherwise provided in 
this section III. of this appendix A, for a recourse obligation, 
direct credit substitute, or an asset- or mortgage-backed security 
that is rated investment grade, the full amount of the credit 
enhanced assets from which risk of credit loss is directly or 
indirectly retained or assumed by the bank is assigned to the 50 
percent risk category, regardless of the face amount of the bank's 
risk position.
    (3) Risk participations and syndications in direct credit 
substitutes--(i) In the case of direct credit substitutes in which a 
risk participation <SUP>23</SUP> 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.<SUP>24</SUP> 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

[[Page 59966]]

institution or foreign bank is assigned to the 20 percent risk 
category.<SUP>25</SUP>
---------------------------------------------------------------------------

    \23\ That is, a participation in which the originating bank 
remains liable to the beneficiary for the full amount of the direct 
credit substitute if the party that has acquired the participation 
fails to pay when the instrument is drawn.
    \24\ A risk participation in bankers acceptances conveyed to 
other institutions is also assigned to the risk category appropriate 
to the institution acquiring the participation or, if relevant, the 
guarantor or nature of the collateral.
    \25\ Risk participations with a remaining maturity of over one 
year that are conveyed to non-OECD banks are to be assigned to the 
100 percent risk category, unless a lower risk category is 
appropriate to the obligor, guarantor, or collateral.
---------------------------------------------------------------------------

    (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.<SUP>26</SUP>
---------------------------------------------------------------------------

    \26\ For example, if a bank has a 10 percent share of a $10 
syndicated direct credit substitute that provides credit support to 
a $100 loan, then the bank's $1 pro rata share in the enhancement 
means that a $10 pro rata share of the loan is included in risk 
weighted assets.
---------------------------------------------------------------------------

    (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,<SUP>27</SUP> 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.
---------------------------------------------------------------------------

    \27\ A privately-issued mortgage-backed security may be treated 
as an indirect holding of the underlying assets provided that: (1) 
The underlying assets are held by an independent trustee and the 
trustee has a first priority, perfected security interest in the 
underlying assets on behalf of the holders of the security; (2) 
either the holder of the security has an undivided pro rata 
ownership interest in the underlying mortgage assets or the trust or 
single purpose entity (or conduit) that issues the security has no 
liabilities unrelated to the issued securities; (3) the security is 
structured such that the cash flow from the underlying assets in all 
cases fully meets the cash flow requirements of the security without 
undue reliance on any reinvestment income; and (4) there is no 
material reinvestment risk associated with any funds awaiting 
distribution to the holders of the security. In addition, if the 
underlying assets of a mortgage-backed security are composed of more 
than one type of assets, for example, U.S. Government-sponsored 
agency securities and 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.
---------------------------------------------------------------------------

* * * * *
    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. * * * <SUP>39</SUP> * * *
---------------------------------------------------------------------------

    \39\ a. Loans that qualify as loans secured by one-to four-
family residential properties or multifamily residential properties 
are listed in the instructions to the commercial bank call report. 
In addition, for risk-based capital purposes, loans secured by one-
to four-family residential properties include loans to builders with 
substantial project equity for the construction of one-to four-
family residences that have been presold under firm contracts to 
purchasers who have obtained firm commitments for permanent 
qualifying mortgage loans and have made substantial earnest-money 
deposits. 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.
---------------------------------------------------------------------------

* * * * *
    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.<SUP>42</SUP> 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;<SUP>43</SUP> 
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.
---------------------------------------------------------------------------

    \42\ Such assets include all nonlocal-currency claims on, and 
the portions of claims that are guaranteed by, non-OECD central 
governments and those portions of local-currency claims on, or 
guaranteed by, non-OECD central governments that exceed the local-
currency liabilities held by subsidiary depository institutions.
    \43\ Customer liabilities on acceptances outstanding involving 
nonstandard risk claims, such as claims on U.S. depository 
institutions, are assigned to the risk category appropriate to the 
identity of the obligor or, if relevant, the nature of the 
collateral or guarantees backing the claims. Portions of acceptances 
conveyed as risk participations to U.S. depository institutions or 
foreign banks are assigned to the 20 percent risk category 
appropriate to short-term claims guaranteed by U.S. depository 
institutions and foreign banks.
---------------------------------------------------------------------------

    (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

[[Page 59967]]

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 risk-weighted assets in two steps. The face amount 
is first multiplied by a credit conversion factor, except for direct 
credit substitutes and recourse obligations as discussed 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.<SUP>44</SUP> Attachment IV to this appendix A sets forth 
the conversion factors for various types of off-balance-sheet items.
---------------------------------------------------------------------------

    \44\ The sufficiency of collateral and guarantees for off-
balance-sheet items is determined by the market value of the 
collateral of the amount of the guarantee in relation 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.
---------------------------------------------------------------------------

    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,<SUP>45</SUP> and partly-paid shares and securities; they do 
not include commitments to make residential mortgage loans or 
forward foreign exchange contracts.
---------------------------------------------------------------------------

    \45\ Forward forward deposits accepted are treated as interest 
rate 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

[[Page 59968]]

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 asset- or mortgage-backed security that is retained, 
assumed, or issued in connection with an asset securitization and 
that is rated with a reasonable expectation that, in the near 
future:
    (i) The position would be sold to investors relying on the 
rating; or
    (ii) A third party would, in reliance on the rating, enter into 
a transaction such as a purchase, loan, or repurchase agreement 
involving the position.
    (b) Amount of position to be included in risk-weighted assets--
(1) Determining the credit equivalent amount of recourse obligations 
and direct credit substitutes. The credit equivalent amount for a 
recourse obligation or direct credit substitute (except as otherwise 
provided in paragraph III.B.3.(b)(2) of this appendix A) is the full 
amount of the credit enhanced assets from which risk of credit loss 
is directly or indirectly retained or assumed. This credit 
equivalent amount is assigned to the risk weight appropriate to the 
obligor, or if relevant, the guarantor or nature of any collateral. 
Thus, a 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 
mortgage-backed securities. A traded position is eligible for the 
risk-based capital treatment described in this paragraph if it has 
been rated at least investment grade by a nationally-recognized 
statistical rating organization. A recourse obligation or direct 
credit substitute that is not a traded position is eligible for the 
treatment described in this paragraph if it has been rated at least 
investment grade by two nationally-recognized statistical rating 
organizations, the ratings are publicly available, the ratings are 
based on the same criteria used to rate securities sold to the 
public, and the recourse obligation or direct credit substitute 
provides credit enhancement to a securitization in which at least 
one position is traded.
    (i) Highest investment grade. Except as otherwise provided in 
section III. of this appendix A, the face amount of a recourse 
obligation, direct credit substitute, or an 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 mortgage-backed security that is 
rated investment grade, the full amount of the credit enhanced 
assets from which risk of credit loss is directly or indirectly 
retained or assumed by the banking organization is assigned to the 
50 percent risk category, regardless of the face amount of the 
banking organization's risk position.
    (3) Risk participations and syndications in direct credit 
substitutes--(i) In the case of direct credit substitutes in which a 
risk participation <SUP>26</SUP> 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.<SUP>27</SUP> 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.<SUP>28</SUP>
---------------------------------------------------------------------------

    \26\ That is, a participation in which the originating banking 
organization remains liable to the beneficiary for the full amount 
of the direct credit substitute if the party that has acquired the 
participation fails to pay when the instrument is drawn.
    \27\ A risk participation in bankers acceptances conveyed to 
other institutions is also assigned to the risk category appropriate 
to the institution acquiring the participation or, if relevant, the 
guarantor or nature of the collateral.
    \28\ Risk participations with a remaining maturity of over one 
year that are conveyed to non-OECD banks are to be assigned to the 
100 percent risk category, unless a lower risk category is 
appropriate to the obligor, guarantor, or collateral.
---------------------------------------------------------------------------

    (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.

[[Page 59969]]

    (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.<SUP>29</SUP>
---------------------------------------------------------------------------

    \29\ For example, if a banking organization has a 10 percent 
share of a $10 syndicated direct credit substitute that provides 
credit support to a $100 loan, then the banking organization $1 pro 
rata share in the enhancement means that a $10 pro rata share of the 
loan is included in risk-weighted assets.
---------------------------------------------------------------------------

    (c) Limitations on risk-based capital requirements--(1) Low-
level recourse. If the maximum contractual liability or exposure to 
loss retained or assumed by a banking organization in connection 
with a recourse obligation or a direct credit substitute is less 
than the effective risk-based capital requirement for the enhanced 
assets, the risk-based capital requirement is limited to the maximum 
contractual liability or exposure to loss, less any recourse 
liability account established in accordance with generally accepted 
accounting principles. This limitation does not apply to assets sold 
with implicit recourse.
    (2) Mortgage-related securities or participation certificates 
retained in a mortgage loan swap. If a banking organization holds a 
mortgage-related security or a participation certificate as a result 
of a mortgage loan swap with recourse, capital is required to 
support the recourse obligation plus the percentage of the mortgage-
related security or participation certificate that is not covered by 
the recourse obligation. The total amount of capital required for 
the on-balance sheet asset and the recourse obligation, however, is 
limited to the capital requirement for the underlying loans, 
calculated as if the banking organization continued to hold these 
loans as an on-balance sheet asset.
    (3) Related on-balance sheet assets. If a recourse obligation or 
direct credit substitute subject to section III.B.3. of this 
appendix A also appears as a balance sheet asset, the balance sheet 
asset is not included in a banking 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 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,<SUP>30</SUP> 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.
---------------------------------------------------------------------------

    \30\ A privately-issued mortgage-backed security may be treated 
as an indirect holding of the underlying assets provided that: (1) 
the underlying assets are held by an independent trustee and the 
trustee has a first priority, perfected security interest in the 
underlying assets on behalf of the holders of the security; (2) 
either the holder of the security has an undivided pro rata 
ownership interest in the underlying mortgage assets or the trust or 
single purpose entity (or conduit) that issues the security has no 
liabilities unrelated to the issued securities; (3) the security is 
structured such that the cash flow from the underlying assets in all 
cases fully meets the cash flow requirements of the security without 
undue reliance on any reinvestment income; and (4) there is no 
material reinvestment risk associated with any funds awaiting 
distribution to the holders of the security. In addition, if the 
underlying assets of a mortgage-backed security are composed of more 
than one type of assets, for example, U.S. Government-sponsored 
agency securities and 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.
---------------------------------------------------------------------------

* * * * *
    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.<SUP>45</SUP> 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; 
<SUP>46</SUP> 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.
---------------------------------------------------------------------------

    \45\ Such assets include all nonlocal currency claims on, and 
the portions of claims that are guaranteed by, non-OECD central 
governments and those portions of local currency claims on, or 
guaranteed by, non-OECD central governments that exceed the local 
currency liabilities held by subsidiary depository institutions.
    \46\ Customer liabilities on acceptances outstanding involving 
nonstandard risk claims, such as claims on U.S. depository 
institutions, are assigned to the risk category appropriate to the 
identity of the obligor or, if relevant, the nature of the 
collateral or guarantees backing the claims. Portions of acceptances 
conveyed as risk participations to U.S. depository institutions or 
foreign banks are assigned to the 20 percent risk category 
appropriate to short-term claims guaranteed by U.S. depository 
institutions and foreign banks.
---------------------------------------------------------------------------

    (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 risk-weighted assets in two steps. The face 
amount is first multiplied by a credit conversion factor, except for 
direct credit substitutes and recourse obligations as discussed 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.<SUP>47</SUP> Attachment IV to this 
appendix A sets forth the conversion factors for various types of 
off-balance-sheet items.
---------------------------------------------------------------------------

    \47\ The sufficiency of collateral and guarantees for off-
balance-sheet items is determined by the market value of the 
collateral of the amount of the guarantee in relation to the face 
amount of the item, except for derivative contracts, for which this 
determination is generally made in relation to the credit equivalent 
amount. Collateral and guarantees are subject to the same provisions 
noted under section III.B. of this appendix A.
---------------------------------------------------------------------------

    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

[[Page 59970]]

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,<SUP>48</SUP> and partly-paid shares and securities; they do 
not include commitments to make residential mortgage loans or 
forward foreign exchange contracts.
---------------------------------------------------------------------------

    \48\ Forward forward deposits accepted are treated as interest 
rate contracts.
---------------------------------------------------------------------------

    (c) Securities lent by a banking organization are treated in one 
of two ways, depending upon whether the lender is at risk of loss. 
If a banking organization, as agent for a customer, lends the 
customer's securities and does not indemnify the customer against 
loss, then the transaction is excluded from the risk-based capital 
calculation. If, alternatively, a bank lends its own securities or, 
acting as agent for a customer, lends the customer's securities and 
indemnifies the customer against loss, the transaction is converted 
at 100 percent and assigned to the risk weight category appropriate 
to the obligor or, if applicable, to any collateral delivered to the 
lending banking organization or the independent custodian acting on 
the lending banking organization's behalf. Where a banking 
organization is acting as agent for a customer in a transaction 
involving the lending or sale of securities that is collateralized 
by cash delivered to the banking organization, the transaction is 
deemed to be collateralized by cash on deposit in the banking 
organization for purposes of determining the appropriate risk-weight 
category, provided that any indemnification is limited to no more 
than the difference between the market value of the securities and 
the cash collateral received and any reinvestment risk associated 
with that cash collateral is borne by the customer.
* * * * *
    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 mortgage-backed security that is retained, assumed, or 
issued in connection with an asset securitization and that has 
received a credit rating from a nationally recognized statistical 
rating organization. A position is rated investment grade if it has 
received a credit rating that falls within one of the four highest 
rating categories used by the organization (e.g., at 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

[[Page 59971]]

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 
mortgage-backed securities. Notwithstanding paragraph B.5.(b)(i) of 
this section, a traded position is eligible for the following risk-
based capital treatment. A recourse obligation or direct credit 
substitute that is not a traded position also is eligible for the 
following treatment if it has been rated at least investment grade 
by two nationally recognized statistical rating organizations, the 
ratings are publicly available, the ratings are based on the same 
criteria used to rate securities sold to the public, and the 
recourse obligation or direct credit substitute provides credit 
enhancement to a securitization in which there is at least one 
traded position.
    (1) Highest investment grade. The face amount of a recourse 
obligation, direct credit substitute, or an asset- or mortgage-
backed security that is rated in the highest investment grade 
category is assigned to the 20 percent risk category.
    (2) Other investment grade. [Option 1--Face Value Treatment] The 
face amount of a recourse obligation, direct credit substitute, or 
an asset- or mortgage-backed security that is rated investment grade 
(but not in the highest investment grade category) is assigned to 
the 100 percent risk category.
    [Option 2--Modified Gross-Up] For a recourse obligation, direct 
credit substitute, or an asset- or mortgage-backed security that is 
rated investment grade (but not in the highest investment grade 
category), the full amount of the credit enhanced assets from which 
risk of credit loss is directly or indirectly retained or assumed by 
the bank is assigned to the 50 percent risk category, regardless of 
the face amount of the bank's risk position. For a senior asset-or 
mortgage-backed security which provides no credit enhancement, this 
means that the face amount of the security is assigned to the 50 
percent risk category.
    (iii) Risk participations and syndications in direct credit 
substitutes. (1) In the case of a direct credit substitute in which 
a risk participation <SUP>14</SUP> 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.<SUP>15</SUP> 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. <SUP>16</SUP>
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    \14\ That is, a participation in which the originating bank 
remains liable to the beneficiary for the full amount of the direct 
credit substitute if the party that has acquired the participation 
fails to pay when the instrument is drawn.
    \15\ A risk participation in a bankers acceptance conveyed to 
another institution is also assigned to the risk category 
appropriate to the institution acquiring the participation or, if 
relevant, the guarantor or nature of the collateral.
    \16\ A risk participation with a remaining maturity of over one 
year that is conveyed to a non-OECD bank is to be assigned to the 
100 percent risk category, unless a lower risk category is 
appropriate to the obligor, guarantor, or collateral.
---------------------------------------------------------------------------

    (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. 
<SUP>17</SUP>
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    \17\ For example, if a bank has a 10 percent share of a $10 
syndicated direct credit substitute that provides credit support to 
a $100 loan, then the bank's $1 pro rata share in the enhancement 
means that a $10 pro rata share of the loan is included in risk-
weighted assets.
---------------------------------------------------------------------------

    (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

[[Page 59972]]

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, <SUP>18</SUP> 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), 
principal-only strips (POs), and similar instruments, are assigned 
to the 100 percent risk weight category, regardless of the issuer or 
guarantor.
---------------------------------------------------------------------------

    \18\ A privately-issued mortgage-backed security may be treated 
as an indirect holding of the underlying assets provided that: (1) 
The underlying assets are held by an independent trustee and the 
trustee has a first priority, perfected security interest in the 
underlying assets on behalf of the holders of the security; (2) 
either the holder of the security has an undivided pro rata 
ownership interest in the underlying mortgage assets or the trust or 
single purpose entity (or conduit) that issues the security has no 
liabilities unrelated to the issued securities; (3) the security is 
structured such that the cash flow from the underlying assets in all 
cases fully meets the cash flow requirements of the security without 
undue reliance on any reinvestment income; and (4) there is no 
material reinvestment risk associated with any funds awaiting 
distribution to the holders of the security. In addition, if the 
underlying assets of a mortgage-backed security are composed of more 
than one type of asset, the entire mortgage-backed security is 
generally assigned to the category appropriate to the highest risk-
weighted asset underlying the issue.
---------------------------------------------------------------------------

    (e) Other stripped mortgage-backed securities. All other 
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 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\ * * *
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    \33\ The types of loans that qualify as loans secured by 
multifamily residential properties are listed in the instructions 
for preparation of the Consolidated Reports of Condition and Income. 
In addition, from the standpoint of the selling bank, when a 
multifamily residential property loan is sold subject to a pro rata 
loss sharing arrangement which provides for the purchaser of the 
loan to share in any loss incurred on the loan on a pro rata basis 
with the selling bank, that portion of the loan is not subject to 
the risk-based capital standards. In connection with sales of 
multifamily residential property loans in which the purchaser of the 
loan shares in any loss incurred on the loan with the selling 
institution on other than a pro rata basis, the selling bank must 
treat these other loss sharing arrangements in accordance with 
section II.B.5. of this appendix A.
---------------------------------------------------------------------------

* * * * *
    4. In appendix A to part 325, section II.C., Category 4--100 
Percent Risk Weight is revised to read as follows:
* * * * *
    II. * * *
    C. * * *
    Category 4--100 Percent Risk Weight. a. All assets not included 
in the categories above are assigned to this category, which 
comprises standard risk assets. The bulk of the assets typically 
found in a loan portfolio would be assigned to the 100 percent 
category.
    b. This category includes:
    (1) Long-term claims on, and the portions of long-term claims 
that are guaranteed by, non-OECD banks, and all claims on non-OECD 
central governments that entail some degree of transfer risk; 
<SUP>37</SUP>
---------------------------------------------------------------------------

    \37\ Such assets include all nonlocal-currency claims on, and 
the portions of claims that are guaranteed by, non-OECD central 
governments and those portions of local-currency claims on, or 
guaranteed by, non-OECD central governments that exceed the local-
currency liabilities held by subsidiary depository institutions.
---------------------------------------------------------------------------

    (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; <SUP>38</SUP>
---------------------------------------------------------------------------

    \38\ Customer liabilities on acceptances outstanding involving 
nonstandard risk claims, such as claims on U.S. depository 
institutions, are assigned to the risk category appropriate to the 
identity of the obligor or, if relevant, the nature of the 
collateral or guarantees backing the claims. Portions of acceptances 
conveyed as risk participations to U.S. depository institutions or 
foreign banks are assigned to the 20 percent risk category 
appropriate to short-term claims guaranteed by U.S. depository 
institutions and foreign banks.
---------------------------------------------------------------------------

    (5) Investments in fixed assets, premises, and other real estate 
owned;
    (6) Common and preferred stock of corporations, including stock 
acquired for debts previously contracted;
    (7) Commercial and consumer loans (except (a) those assigned to 
lower risk categories due to recognized guarantees or collateral and 
(b) loans secured by residential property that qualify for a lower 
risk weight);
    (8) All stripped mortgage-backed securities and similar 
instruments;
    (9) Industrial-development bonds and similar obligations issued 
under the auspices of state or political subdivisions of the OECD-
based group of countries for the benefit of a private party or 
enterprise where that party or enterprise, not the government 
entity, is obligated to pay the principal and interest; and
    (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

[[Page 59973]]

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 risk-weighted assets in two steps. The face amount 
is first multiplied by a credit conversion factor, except for direct 
credit substitutes and recourse obligations as discussed 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.<SUP>39</SUP>
---------------------------------------------------------------------------

    \39\ The sufficiency of collateral and guarantees for off-
balance-sheet items is determined by the market value of the 
collateral of the amount of the guarantee in relation to the face 
amount of the item, except for derivative contracts, for which this 
determination is generally made in relation to the credit equivalent 
amount. Collateral and guarantees are subject to the same provisions 
noted under section II.B. of this appendix A.
---------------------------------------------------------------------------

    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, <SUP>40</SUP> and partly-paid shares and securities, but 
they do not include commitments to make residential mortgage loans 
or forward foreign exchange contracts.
---------------------------------------------------------------------------

    \40\ Forward forward deposits accepted are treated as interest 
rate 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 risk-based capital 
calculation. On the other hand, if a bank lends its own securities 
or, acting as agent for a customer, lends the customer's securities 
and indemnifies the customer against loss, the transaction is 
converted at 100 percent and assigned to the risk weight category 
appropriate to the obligor or, if applicable, to any collateral 
delivered to the lending bank or the independent custodian acting on 
the lending bank's behalf. When a bank is acting as a customer's 
agent in a transaction involving the loan or sale of the customer's 
securities that is collateralized by cash delivered to the lending 
bank, the transaction is deemed to be collateralized by cash on 
deposit with the bank for purposes of determining the appropriate 
risk-weight category, provided that any indemnification is limited 
to no more than the difference between the market value of the 
securities lent or sold and the cash collateral received, and any 
reinvestment risk associated with the cash collateral is borne by 
the customer.
* * * * *
    6. In appendix A to part 325, Table II--Summary of Risk Weights and 
Risk Categories is amended under Category 2--20 Percent Risk Weight by 
adding a new paragraph (13) to read as follows:
* * * * *

Table II--Summary of Risk Weights and Risk Categories

* * * * *
    Category 2--20 Percent Risk Weight
* * * * *
    (13) The face amount of a recourse obligation, direct credit 
substitute, or asset- or mortgage-backed security that is rated in 
the highest investment grade category.
* * * * *
    7. In appendix A to part 325, Table II--Summary of Risk Weights and 
Risk Categories is amended under Category 3--50 Percent Risk Weight by 
adding a new paragraph (6) to read as follows:
* * * * *

Table II--Summary of Risk Weights and Risk Categories

* * * * *

Category 3--50 Percent Risk Weight

* * * * *
    [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 Off-Balance Sheet Items, the item ``100 Percent Conversion Factor'' 
is revised and a new item ``Credit Conversion for Recourse Obligations 
and Direct Credit Substitutes'' is added after the item ``Zero Percent 
Conversion Factor'' to read as follows:
* * * * *

Table III--Credit Conversion Factors for Off-Balance Sheet Items 100 
Percent Conversion Factor

100 Percent Conversion Factor

    (1) Sale and repurchase agreements, if not already included on 
the balance sheet.
    (2) Forward agreements representing contractual obligations to 
purchase assets, including financing facilities, with drawdown 
certain at a specified future date.
    (3) Securities lent, if the lending bank is exposed to risk of 
loss.
* * * * *

Credit Conversion for Recourse Obligations and Direct Credit 
Substitutes

    The credit equivalent amount for an off-balance sheet recourse 
obligation or direct credit substitute:
    (1) That is not rated at least investment grade is the full 
amount of the credit enhanced assets from which risk of loss is 
directly or indirectly retained or assumed, subject to the low-level 
recourse rule.
    (2) That is rated in the highest investment grade category is 
its face amount.
    (3) That is rated investment grade, but below the highest 
investment grade category, is [Option 1--Face Value Treatment] its 
face amount.
    [Option 2--Modified Gross-Up] the full amount of the credit 
enhanced assets from which risk of credit loss is directly or 
indirectly retained or assumed.
* * * * *
    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 
``Sec. 567.6(a)(vi)'' and adding in lieu thereof the phrase 
``Sec. 567.6(a)(1)(vi)'' and by revising paragraph (kk), to read as 
follows:


Sec. 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

[[Page 59974]]

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:


Sec. 567.6  Risk-based capital credit risk-weight categories.

    (a) Risk-weighted assets. Risk-weighted assets equal risk-weighted 
on-balance sheet assets (as computed under paragraph (a)(1) of this 
section), plus risk-weighted 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 Sec. 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 
mortgage-backed 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 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 (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.

[[Page 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 Sec. 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 Sec. 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 Sec. 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 on-balance 
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 on-balance sheet assets under paragraph (a)(1) of this 
section, and the related recourse obligations and direct credit 
substitutes are risk-weighted under this paragraph (a)(3); and
    (2) Purchased subordinated interests that are high quality 
mortgage-related securities are not subject to risk weighting under 
this paragraph (a)(3). Rather, the face values of these assets are 
risk-weighted as on-balance sheet assets under paragraph (a)(1)(ii)(H) 
of this section.
    (vi) Obligations of subsidiaries. If a savings association retains 
a recourse obligation or assumes a direct credit substitute on the 
obligation of a subsidiary that is not an includable subsidiary, and 
the recourse obligation or direct credit substitute is an equity or 
debt investment in that subsidiary under generally accepted accounting 
principles, the face amount of the recourse obligation or direct credit 
substitute is deducted for capital under Secs. 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

[[Page 59976]]

representations and warranties on the loans other than standard 
representation and warranties as defined in this section.
    (2) Rated means, with respect to an instrument or obligation, that 
the instrument or obligation has received a credit rating from a 
nationally-recognized statistical rating organization. An instrument or 
obligation is rated investment grade if it has received a credit rating 
that falls within one of the four highest rating categories used by the 
organization. An instrument or obligation is rated in the highest 
investment grade if it has received a credit rating that falls within 
the highest rating category used by the organization.
    (3) Recourse means the retention, in form or in substance, of any 
risk of credit loss directly or indirectly associated with a 
transferred asset, that exceeds a pro rata share of the savings 
association's claim on the asset. If a savings association has no claim 
on a transferred asset, then the retention of any risk of credit loss 
is recourse. A recourse obligation typically arises when an institution 
transfers its assets and retains an obligation to repurchase the 
assets, or to absorb losses due to a default of principal or interest 
or any other deficiency in the performance of the underlying obligor or 
some other party. Recourse may exist implicitly where a savings 
association provides credit enhancement beyond any contractual 
obligation to support the assets it has sold. Recourse obligations 
include, but are not limited to:
    (i) Representations and warranties on the transferred assets other 
than standard representations and warranties as defined in this 
section;
    (ii) Retained loan servicing assets if the servicer is responsible 
for losses associated with the loans serviced (other than a servicer 
cash advance as defined in this section);
    (iii) Retained subordinated interests or securities that absorb 
more than their pro rata share of losses from the underlying assets;
    (iv) Assets sold under an agreement to repurchase; and
    (v) Loan strips sold without direct recourse where the maturity of 
the transferred loan is shorter than the maturity of the commitment.
    (4) Servicer cash advance means funds that a residential mortgage 
loan servicer advances to ensure an uninterrupted flow of payments or 
the timely collection of residential mortgage loans, including 
disbursements made to cover foreclosure costs or other expenses arising 
from a mortgage loan to facilitate its timely collection. A servicer 
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


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