FDIC Approves Final Rule on Recourse and Residuals

by: Marty Rosenblatt, Deloitte Touche Tohmatsu, Oct. 23, 2001

[Martin Rosenblatt is an internationally acclaimed expert in accounting and regulatory issues on securitization and has several articles on this site – see our articles section and accounting issues section for links.: VK]

The FDIC has approved a final rule revising the regulatory capital treatment of recourse, direct credit substitutes, and residual interests in securitizations. The Fed, OCC and OTS are expected to take similar action shortly.

Effective Date

The final rule is effective for transactions settled on or after January 1, 2002, with a one-year transition rule for transactions settled before that date. For transactions settled before January 1, 2002, banks can delay adoption of any provision until December 31, 2002 if adoption would be unfavorable, i.e. an increased capital requirement. On the other hand, a bank could elect to adopt any provision as soon as the new rule is published in the Federal Register if the result would be favorable, i.e. a reduced capital requirement. A reduced capital requirement could result, for example, due to the permitted netting of a deferred tax liability against a residual asset or from applying reductions for rated retained interests. An increased capital requirement could result, for example, if the amount of the retained residual interest exceeds the full risk-based-capital requirement on the assets transferred.

THIS SYNOPSIS DEALS ONLY WITH A LIMITED PORTION OF THE RULE, RELATING TO RISK-BASED-CAPITAL REQUIREMENTS WHEN A BANK OR THRIFT RETAINS ONE OR MORE SUBORDINATED RESIDUAL INTERESTS IN THEIR OWN SECURITIZATIONS. THIS SYNOPSIS DOES NOT ADDRESS IN ANY MANNER THE MANY SIGNIFICANT CHANGES IN REGULATORY CAPITAL RESULTING FROM THE MANY OTHER PORTIONS OF THE RULE DEALING WITH TRANSFERS OTHER THAN SECURITIZATIONS OR BANKS ENHANCING THIRD PARTY ASSETS.

Dollar-For-Dollar Capital Requirement

The rule replaces the existing "low-level recourse" rule with a so-called "dollar-for-dollar" capital rule. In other words, a bank must generally maintain risk-based capital equal to the "face amount" of the residual interest that is retained on the balance sheet (net of any existing associated deferred tax liabilities) without regard to whether such amount is less than or greater than the full risk-based capital requirement for the assets securitized. Thus, the capital requirement for residual interests is not limited by the 8% capital in place under the current risk-based capital regime, but still can be less than the 8% of assets whenever the retained residual is less than 8% of assets.

Some definitions are in order:

• 1. A Residual Interest means any on-balance sheet asset that represents a retained beneficial interest in a securitization accounted for as a sale, and that exposes the bank to ANY credit risk directly or indirectly associated with the transferred asset that exceeds a pro rata share of that bank's claim on the asset. Residual interests include "credit-enhancing interest-only strips"{see below}, spread accounts, cash collateral accounts, retained subordinated interests and other forms of over-collateralization. The FDIC also listed accrued but uncollected interest on transferred assets (presumably in credit card securitizations) that, when collected, will be available to serve in a credit-enhancing capacity, as another example of a residual interest. Residual interests generally do not include interests purchased from a third party other than purchased credit-enhancing interest-only strips (defined below).
• 2. Face Amount means (1) the amortized cost of an asset, if not held in a trading account (e.g. accounted for as held-to-maturity[if permitted] or available-for-sale), or (2) the fair value of the asset if held in a trading account.

Deferred Tax Liability

In order to reduce the capital requirement for deferred tax liabilities, the liability must be on the balance sheet and specifically identifiable with the residual interest. For example, if a securitization was accounted for as a sale for GAAP but treated as debt-for-tax, and gain on sale was recognized in an amount approximating the present value of a retained I/O strip, then it is likely that deferred taxes would have been provided on that timing difference, which will reverse over the life of the securitization. On the other hand, if the residual interest was represented by a deposit into a cash collateral account, it is unlikely that there would be any associated deferred taxes.

Permitted Reductions For Rated Retained and Purchased Interests

Certain rated residual interests (with the exception of "credit-enhancing interest-only strips") and rated ABS and MBS are not subjected to the full dollar-for-dollar capital treatment. Prior to the new rule, all purchased ABS were placed in the same category. The following table presents the manner in which the ratings-based-approach would typically be applied, for example, to a "second-dollar" loss position. Note the rating designations used in the table are illustrative only and do not indicate any preference for, or endorsement of, any particular rating agency designation system by the regulators. 
 

Example Rating	Risk-Weight	Capital Required for each $1 of Investment
a)Investment Grade:
AAA or AA*	20%	1.6 cents
A*	50%	4 cents
BBB	100%	8 cents
b)One Category Below: BB	200%	16 cents
c)B and below, and all Unrated	Not eligible for reduction	100 cents
* IOs and POs, regardless of rating, are not eligible for less than 100%weighting.

 

Keep in mind that a 200% risk-weight is a lower capital charge than dollar-for-dollar. The capital requirement for a position is computed by multiplying the face amount of the position by the appropriate risk weight determined from the table. Thus, under the new rule, securities receiving the third-highest rating, A, require 4% capital, while those with the lowest investment grade, BBB, require 8%. B-rated or unrated securities require dollar-for-dollar capital.

Only one rating is required if there is a reasonable expectation that in the near future, either (1) the position may be traded; or (2) the position may be used in a secured loan or repo transaction in which a third party relies on the rating. Otherwise, to qualify for the ratings-based approach, the position must be rated by more than one rating agency, the ratings must be the equivalent of BB or better by all rating agencies providing a rating, the ratings must be publicly available, and the ratings must be based on the same criteria used to rate securities that are traded. If the ratings are different, the lowest rating will determine the risk-weight.

In the absence of external ratings, the regulators have decided for the present not to allow banks to use internal ratings, program ratings or computer programs to apply a risk-based capital treatment more favorable than a dollar-for-dollar capital requirement to "residual interests," although such methodology will be allowed for other types of exposures.

If a bank sells a residual interest to a third-party and writes a credit derivative to cover the credit risk associated with that asset, the selling bank must continue to risk weight, and hold capital against, that asset as a residual as if the asset had not been sold. The same holds true if a bank transfers the risk on a residual interest through guarantees or other credit risk mitigation techniques, and then reassumes this risk in any form.

Concentration Limit For Certain Residual Interests

The rule imposes a concentration limit on "credit-enhancing interest-only strips (CEIOs)", whether retained or purchased, to 25% of Tier 1 capital, (Core Capital for Thrifts). For regulatory capital purposes only, any amount of CEIOs that exceeds the 25% limit will be deducted from Tier 1 capital. CEIOs that are not deducted from Tier 1 capital, along with all other residual interests are subject to the dollar-for-dollar requirements, as described above.

Some more definitions are in order:

• 3. A Credit-Enhancing Interest-Only Strip means an on-balance sheet asset that (1) represents the contractual right to receive some or all of the interest due on transferred assets and (2) exposes the bank to credit risk that exceeds its pro rata claim on the underlying assets. Thus, CEIOs include any balance sheet asset that represents the contractual right to receive some or all of the remaining interest cash flow generated from assets that have been transferred to an SPE, after taking into account trustee and other administrative expenses, interest payments to investors, servicing fees, and reimbursements to investors for losses attributable to the beneficial interests they hold. An instrument with these characteristics will still be considered a CEIO even if it is entitled to some principal.
• 4. Tier 1(Core) Capital must equal or exceed 4% of risk-weighted assets (total capital must equal or exceed 8%) and is comprised of common stockholders' equity, noncumulative perpetual preferred stock, plus minority interest in subsidiaries LESS most intangible assets as well as deductions for the following types of assets when they exceed the relevant capital limitations (e.g. 25% of Tier 1 for CEIOs): certain mortgage servicing assets, nonmortgage servicing assets, purchased credit card relationships, CEIOs, and deferred tax assets.

The following example illustrates the concentration calculation:

A bank has $100 in purchased and retained CEIOs on its balance sheet and Tier 1 capital of $320 (before any disallowed servicing assets, purchased credit card relationships and deferred tax assets). The bank would multiply the Tier 1 capital of $320 by 25%, which is $80. The amount of CEIOs that exceed the concentration limit, in this case, $20, is deducted from Tier 1 capital. The remaining $80 is then subject to the dollar-for-dollar capital charge. The $20 deducted from Tier 1 capital, plus the $80 in total risk-based capital required, equals $100, the balance sheet amount of the CEIOs. Banks may apply a net-of-tax approach on any CEIOs that have been disallowed from Tier 1, as well as to the remaining residual interests subject to the risk-based-capital rule.

Securitizations Accounted for as Financings

When a securitization is accounted for as a financing, no gain is recognized or capital created from an accounting standpoint, which serves to mitigate some of the regulators' concerns. The agencies, however, have said that they will monitor securitization transactions that are accounted for as financings and will factor into the bank's capital adequacy determination the risk exposures being assumed or retained in connection with the transaction.

Additional Authority

The agencies retain the authority to exercise discretion to ensure that banks, as they develop novel financial assets, will be treated appropriately under the regulatory capital standards. Accordingly, they have the right to assign risk positions in securitizations to appropriate risk categories on a case-by-case basis if the credit rating of the risk position is determined to be inappropriate.

Clean-Up Calls

The agencies have had longstanding concerns that a bank may implicitly undertake a credit-enhancing position by exercising a clean-up call option when the credit quality of the securitized loans is deteriorating. An excessively large clean-up call facilitates a securitization servicer's ability to take investors out of a pool to protect them from absorbing credit losses and, thus, may indicate that the servicer has retained or assumed the credit risk on the underlying pool of loans.

Under the final rule, an agreement that permits a bank that is a servicer or an affiliate of the servicer to elect to purchase loans in a pool is not recourse or a direct credit substitute if the agreement permits the bank to purchase the remaining loans in a pool when the balance of those loans is equal to or less than 10% of the original pool balance. {Query: could the 10% relate to the outstanding balance of the bonds, rather than the collateral, as some optional termination provisions are written?}. However, an agreement that permits the remaining loans to be repurchased when their balance is greater than 10% of the original pool balance is considered to be recourse or a direct credit substitute. {Query: could one argue that the portion considered to be recourse should be limited to the excess over 10%?}

Further, to minimize the potential for using such a feature as a means of providing support for a troubled portfolio, the agencies say that a bank that exercises a call should not repurchase any loans in the pool that are 30 days or more past due. Alternatively, the bank should repurchase the loans at the lower of their estimated fair value or their par value plus accrued interest. Regardless of the size of the clean-up call, the agencies will closely scrutinize any transaction where the banking organization repurchases deteriorating assets for an amount greater than a reasonable estimate of their fair value and will take action accordingly. {Query: would their concerns be mitigated when the bank holds the first-loss position and has provided dollar-for-dollar capital.}

Servicer Advances

Cash advances made by residential mortgage loan servicers to ensure an uninterrupted flow of payments to investors are specifically excluded from the definition of recourse, provided that the residential mortgage loan servicer is entitled to reimbursement for any significant advances and this reimbursement is not subordinate to other claims. The bank, as servicer, is expected to make an independent credit assessment of the likelihood of repayment of the servicer advance, before deciding to advance and should only make such an advance if prudent lending standards are met. {Query: what about asset types other than residential mortgage loans?}

Interaction with Market Risk Rule

Some large, sophisticated banks (but not thrifts) are allowed to apply the "market risk rules." For banks that comply with the market risk rules, positions in the trading book arising from securitizations, should be treated for risk-based capital purposes in accordance with those rules. However, they are still subject to the 25% concentration limit for CEIOs.

Quarterly Valuations

The rule requires that the fair value of servicing assets, purchased credit card relationships and CEIOs be updated at least quarterly and include adjustments for any significant changes in assumptions. The FDIC may require independent fair value estimates where they deem it appropriate.