Among other significant impacts, the proposed regulatory changes concerning residuals and risk management for asset-backed banking could contribute to the current surge in collateralized debt obligation-type product, said industry sources.

"These new recourse rules are going to have a profound effect on how banks retain subordinated pieces and residuals," said an ABS consultant who works closely with the regulators. "And [banks] going to have a great deal of incentive to get rid of them, and these arbitrage CLOs look to be the fastest way to get rid of them."

Titled Risk-Based Capital Standards: Recourse and Direct Credit Substitutes, the final set of guidelines was published in the federal register last week, thereupon entering a 90-day commentary period.

Of incentives for banks to dispose retained assets, the guidelines require significant capital support to match residuals, combined with rigid accounting procedures.

"Basically, they're going to give investor banks a break, when they buy the high rated classes," the consultant said. "But the lower rated classes, if they're retained or purchased by a bank are going to require significant capital support, or be deducted from capital completely. Now if that's the case there's a penalty for holding them, a bigger penalty than there is now."

"We proposed to change the risk weight for triple-A and double-A, which is currently 100%," said Michael Brosnan of the Office of the Comptroller of the Currency. We don't [currently] differentiate between high-quality and low-quality."

However, Brosnan explained, moving down the spectrum, double-B rated retained assets will require a 200% capital risk weight, a significant increase.

Industry specialists are comparing the proposed regulations to the BIS proposal (also know as the Basel Accord), which contains guidelines that could negatively impact asset-backed commercial banks, argues the consultant.

"One is the 20% risk rate for all loan commitment," the consultant said.

Similarly, there is an early amortization provision on credit card deals, requiring a 20% risk weight on the entire deal.

"That's likely to unite the credit card banks and the [asset-backed commercial paper] banks against it," the consultant said.

Regardless the emphasis on risk weighting for low-rated assets, regulators maintain that the guidelines will be beneficial to the growth of ABS.

"I think securitizations in general are going to be more attractive for banks, certainly on the investment side, because we're saying, you got an asset that has spread over Treasury, sure, but it might be low relative to other rated assets, because you only have an 8% capital charge," Brosnan said. "Therefore it's going to be a more attractive investment for banks for the yield relative to the cost of owning it, which includes the capital charge."

The regulations would significantly widen an issuer's investor base, said Brosnan.

Internal Ratings

Of other significant changes, the proposals will allow asset-backed commercial paper banks to determine the quality of their own assets, by using their internal risk management systems.

"They'll be able to determine their own capital requirements for the programs that they support, with some kind of a recourse arrangement," the consultant said.

In 1997 the regulators introduced the notion of using ratings to determine the various capital levels in connection with securitization, which was easy to do as most securitizations are rated. However, the current proposal is the first time they will rely on the banks own internal system.

"It's not as much as a departure as it may seem," the consultant said. "All the asset-backed commercial paper programs are rated they have to be to a certain qualify for inclusion in mutual funds. It will be very easy for the Fed to make a judgement as to whether the bank's internal judgement and the ratings agencies' are consistent."

The consultant predicts that ABCP banks will start to buy receivables from more highly rated companies going forward, as those assets will do very well under the proposed systems.

"However, those programs run like arbitrage deals - using the c-pieces of c-cards and things like that as assets - will not fair to well," the consultant said.

The recent concern with residuals and low quality assets stems from the losses associated with recent bank failures, most notably First National Bank of Keystone, which could cost the FDIC as much as $800 million.

What had been overlooked in the FDIC's attack on subprime assets, however, is the effects on minority lending.

"The point is - and this is a wonderful, regulatory conundrum - a significant percentage of the subprime borrowers are minority borrowers, and this administration has a very strong push for banks to service minority areas, and to lend more freely to minorities," the consultant said.

"So by condemning subprime, or making it more difficult for banks to securitize subprime paper, you really create a situation having the effect of limiting the availability of credit to minorities," he added.

The Review Period

Last week's publication in the federal register marks the third time these regulations in some form or another have been released for review.

However this proposal has evolved quite a bit, said sources on all sides of the issues.

"I assure you this started no later than 1988, when we were just working, [Thomas Boemio of the Federal Reserve] and I, and other people who are still around," Brosnan said.

"But you can tell, had you been following along, that we are pretty close," he added. "I can't guaranty anything, because it would be outright wrong of me or even illegal to do so."

Brosnan explained that, in the 90-day commentary period, various interested parties, such as bankers, lawyers, consultants, and investment houses, will comment on the document.

Then the FDIC, the Federal Reserve, the Office of Thrift Supervision, and the OCC will assemble and collectively review and categorize the comments, and make appropriate adjustments.

If the guidelines are approved, there would be a period of time ranging from a few months to a few years, before the actual regulations go into effect.

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