One of the longest running dramas in bank regulatory history is finally drawing to a close. Led by the FDIC, which issued a draft of its final rule this past week, U.S. regulators are completing work on a risk-based capital proposal that was first presented in 1994. It appeared that completion of this task would await the international risk-based capital proposal from Basel. But apparently U.S. bank regulators decided to produce a final rule even before the Basel rules were completed. The impetus was a desire to set up new capital rules for residuals as soon as possible. Some of the biggest hits to the FDIC's insurance fund have come from banks with large exposures to residual risk - usually from mortgage-related products, such as hi-LTV or sub-prime. And with the economy headed for a serious recession, regulators wanted new residual rules in place tout suite.
Changes for residuals were only first proposed in September 2000, whereas broad risk-based capital changes were proposed in 1994, in 1997 and again in March 2000. Because the separate rules for residuals overlapped the broad risk-based rule changes in several key areas, it was decided to finalize both proposals at the same time. Over the past few years, residual valuation problems (as part of gain-on-sale accounting) helped re-make the home equity and hi-LTV industries. Now, after seven years of debate, they have helped push regulators to produce a final rule on risk-based capital changes.
Highlights
Several key points from the final rule (many are identical to those in the March 2000 proposal), and their possible impact, include:
*Risk weights on CMBS and most ABS sectors will be reduced from 100% to 20%; Jumbo risk weights drop from 50% to 20%. These changes will increase bank demand for ABS, CMBS and Jumbos, but probably only modestly. Many banks are not risk-based capital constrained, others do not invest in these securitized products, and in general, other factors can overwhelm the impact of lower risk weights.
*Capital requirements for residuals will increase. This will increase the cost of banks doing securitizations. However, it will also reduce the number of small banks pursuing a securitization strategy, and reduce the FDIC's risk for those remaining.
*Deferred-an earlier provision requiring credit card banks to put up more capital for their managed assets subject to early amortization.
*Effective-for transactions settled on or after January 1, 2002. For settlements prior to that, banks can delay adoption of any provision until December 31, 2002, if adoption would be unfavorable.
Changing Risk Weights
From an investment point of view, the most significant aspect of these new rules is the change in risk weights for securitized products. For the most part, they are identical to those that appeared in the March 2000 risk-based proposal. (Bank regulators issued risk-based proposals in 1994, 1997 and March 2000.) Risk weights for AAA and AA securities are 20%, for A securities they are 50%, for BBB 100% and for BB 200%. The rules were changed from the March 2000 proposal for B and lower, and for unrated securities. In that earlier proposal these securities were subject to a "gross-up" rule. In the final rule, they require a dollar-for-dollar amount of risk-based capital.
In comparing risk weights "before" and "after" the new proposal in AAA and AA-rated securities, the biggest change is in the CMBS and ABS sectors - many of which will experience a drop in risk weighting from 100% to 20%. From a risk-based capital point of view, this puts most CMBS and ABS on an equal footing with Agency MBS and student loans. Risk weights are also reduced from 50% to 20% on Jumbo whole loans and some home equities (those which qualify as 1st liens).
Bank Investments
Banks make investment decisions at the margin, and if risk weights on a class of assets are reduced relative to others, there will be a realignment of portfolios. For example, under the new rules, a bank can invest in Jumbo residential MBS and receive a 20% rather than a 50% risk weight. Until now (in the MBS sector) the 20% risk weight was reserved for Agency MBS. If a bank does not need the Agency credit, it may well increase its allocation to private label MBS to pick up extra yield. Credit cards are highly liquid securities, but until now carried a 100% risk weight. The drop to 20% makes them much more appealing to many banks.
However, while it is apparent that the new rules will encourage some banks to increase their purchase of ABS, CMBS and Jumbos, it is difficult to make statements about how the banking community as a whole will respond. For some banks, mainly those that already invest in ABS and CMBS, the lower risk weights will probably cause an incremental increase in their allocations to these products. But banks not currently investing in ABS and CMBS may not invest in those sectors simply because of changed risk weights.
Another group of banks, including some super regionals, have significantly reduced the amount of securities they hold in portfolio. They prefer to earn interest from off-balance sheet products that do not add to total assets but can boost return-on-assets. On balance, however, the percentage of securities held by commercial banks has not changed a great deal over the past 20 years. Since 1980, bank securities holdings as a % of total assets fluctuated between 16% and 22%; while today, it's around 17.3%. Historically, during recessions, bank lending contracts and investment in securities rises. As the current recession unfolds and commercial lending declines, we expect to see securities increase as a % of bank assets.
So - there will be plenty of funds available to purchase the securities impacted by the new risk-based capital rules.
Risk-Based Capital Constraint
Another issue is whether a bank's actual risk-based capital is close to its requirement. If a bank has an excess of risk-based capital (as is the case with many banks today), the bank may be less concerned about an investment's risk-weight adjusted yield than its absolute yield. Currently FDIC-insured banks have, on average, risk-based capital of around 12.41%, compared to a minimum requirement of 8.0%. The percentage varies a great deal based on bank size, with the largest banks having the smallest amount of risk-based capital. A bank's response to these new rules will also depend on how capital is allocated within the institution and how profits are measured. If a bank measures investment results on the basis of risk-based capital, investment decisions will be risk-weight sensitive.
On balance - our best guess is that the new risk weights will increase the demand for ABS, CMBS and Jumbo MBS. But that increase will be modest, and could be offset by other factors that drive bank investment decisions.
Special Revolver Rules
One of the most contentious parts of the March 2000 proposal was requiring capital against assets in revolving structures which had the possibility of early amortization. Banks with large credit card portfolios lobbied hard to change that part of the initial rule. In a Salomon-like decision, regulators decided to punt on issuing a final rule (which actually is another indication that regulators were anxious to finalize a ruling on residuals). Their approach seemed to be that in the event of stumbling blocks, simply carve out those issues for later review.
That is apparently what happened with the revolving structure issue. The FDIC memorandum indicated they would, at a later date, issue a specific proposal addressing the revolving securitization topic or "issue a supervisory guidance that discusses how those risks should be taken into account when assessing an institutions capital adequacy." This suggests that banks with large securitized credit card portfolios will eventually face additional capital requirements, but the amount remains to be seen.
Treatment of Residuals
Responding to the heavy losses incurred in several recent bank failures, the FDIC issued fairly strict rules for banks that retain residuals on their balance sheets. It is not much of an exaggeration to say that the FDIC was on a mission when it came to increasing the risk capital required for residuals. Understandably, the FDIC was very unhappy when Keystone Bank in West Virginia and, more recently, Superior Bank, filed bankruptcy and left the FDIC with huge losses to cover. Both of those institutions had not properly reserved for losses associated with the residuals on their books.
Furthermore, the FDIC recently stated that 140 banking institutions have significant exposure to sub-prime lending. These lenders represent just over 1% of all lending institutions, but account for almost 20% of institutions on the FDIC's problem list. And while the recent problems with hi-LTV and sub-prime residuals prompted the new residual rules, the rules apply to all securitized residuals.
The new rules for residuals has two main parts:
a) a concentration limit and
b) a risk-based capital requirement.
The concentration limit states that residuals cannot account for more than 25% of an institution's Tier 1 capital. We should note that 25% is also the point at which the FDIC will put an institution on its list for special monitoring.
The new risk-based capital requirement for residuals is a "dollar-for-dollar" rule, which replaces the existing "low-level recourse" rule. Under the new rule, an institution must keep one dollar of risk-based capital for each dollar of residual face amount. Under "low-level recourse", the capital required was capped at 8%. There is no cap under the new rules, but the required capital can be less than 8% if the face amount of the residual is less than 8% of securitized assets.
The new residual rules will increase the cost of securitization to some institutions, and may even cause some smaller banks to end their securitization programs. However, the new rules also lower the risk to the FDIC insurance fund.
