While the number of community banks entering the securitization market has increased over the last two years, the federal banking agencies are keeping a tighter reign on them in light of recent bank failures.
The Office of the Comptroller of the Currency and Federal Deposit Insurance Corp., along with two other agencies, recently issued guidelines on asset securitization and are actively considering regulatory restrictions that would limit or eliminate retained interest from regulatory capital calculation. In a related development, the banking agencies also came out with guidelines on subprime lending earlier this month.
"The FDIC would like to limit or eliminate the calculation of retained interest from the calculation of regulatory capital, or at least examine this possibility because there were two bank failures this year that were extremely expensive for the FDIC," said FDIC spokesman David Barre. "It's a front burner for the FDIC. We have to see what it's like for the other agencies."
One of the reasons why the bank failures were extremely expensive for the FDIC was the large numbers of retained interests on their books that the institutions placed a value on at the time of their closing. In moving the banks from open institutions to liquidation or receivership entities, those assets had little to no value and were just large losses to the FDIC insurance fund, Barre said.
"Currently about 18 or so institutions have retained interests that exceed 20% of their regulatory capital, so if you back that out of their calculations, that could have an impact on their capital levels," he added.
Sources at the OCC, meanwhile, said that the guideline it just released was not in response to the recent bank failures but rather a reminder to community banks engaged in asset securitization.
"The document that we've issued is a reminder to examiners and bankers that sound practices in asset securitization need to be followed. One of the reasons we issued this right now is this business has grown significantly in the last couple of years - it didn't exist in the community banks three years ago - and we felt quite strongly that this sort of reminder is much needed right now," said Kathryn Dick, director of treasury and market risk at the OCC.
The OCC had issued a handbook two years ago that contained the same regulations as the recent guidelines. "There's nothing new about capital treatment in this document. It's just that the business has expanded so rapidly that some people sort of forget," added Dick.
The recent guideline speaks specifically to community banks. (See Community, p. 3) This is in part because of the value of retained interest relative to capital, she said. "When you look at the retained interest that shows up on the statement of banks like Citibank or MBNA, the number is insignificant. It can be very significant to a community bank with a smaller capital base," Dick said.
The guideline also focuses on retained interests, which becomes an issue when it comes to subprime assets.
Generally, the yield on subprime assets is higher if it is considered in terms of interest-only strips (IOs). The larger the IO strip, the larger the present value of the retained interest reflected on the banks balance sheet.
Also, in a subprime-type credit card, for instance, generally people don't have the luxury of paying off those loans quickly, so the life and maturity on those securitizations will be longer. This means a longer cash flow stream, a factor that makes the retained interest present value much larger, Dick explained.
Asked whether community banks can maintain a staff dedicated solely to working on the nitty-gritty aspects of securitization, Dick answered, "In the document we issued,I think it's quite clear that this is our expectation. But we left some room in there to consider those banks who might do a one-time securitization versus a bank that makes this its line of business."
To Securitize Or Not To Securitize
Experts say that more stringent bank regulations would affect only certain players in the market.
"People with a short term profit orientation might decide that's it's not worth it," a source said. "If somebody is in it to make a quick buck, then it gets harder. Now you have to be more accurate on the losses you're going to have. In that kind of regulatory environment, you're probably going to have to be a little bit more careful on how you're booking things."
In the high loan-to-value market, for instance, the last couple of years saw some players doing public offerings then pumping up their balance sheet to show paper gains, the source said.
"If the securitization was only attractive because you can book inflated gains, people are not going to do it if the regulations are meant to stop that bad practice," the source said. "But those with a clear-eyed view of losses in the HLTV product, in what prepayment spreads are going to be, the regulations might not deter them from pursuing that asset class because they still might think it's worth it."
Players who are looking for huge upside and who are not realistic about losses they could have on the product will not enter the market, the source said.
"What you've done is put out a lot of money to a borrower where the only kind of collection strategy would be to talk the borrower into paying you back like a credit card," the source said. "But instead of having a $10,000 balance on the credit card, you can be talking $30-$50, $70,000 exposures here which is a lot harder to collect. You lent a lot of money to someone without the threat of a foreclosure."
An alternative strategy is to look into somewhat of a lower margin business, like a subprime home-equity type loan, the source said. "At least if the person had a good appraisal on the property he can threaten to foreclose and get his money back."