On September 27, 2000 the Federal Reserve, Comptroller of the Currency, Office of Thrift Supervision, and the Federal Deposit Insurance Corporation published a joint notice of proposed rulemaking that announced their intention to amend the capital rules applicable to banks retaining interests in their own securitizations. The proposal outlines an unusually aggressive regulatory approach to securitization that would make all forms of securitization less attractive for most banks, and the retention of large interests in securitizations unattractive for all banks.
The proposal contains a provision requiring dollar-for-dollar capital support for retained interests in a bank's own securitizations. The existing capital rule for retained interests in securitizations calls for dollar for dollar capital up to a maximum of 8 percent of the securitization supported by the retained interest. The new proposal calls for dollar for dollar capital support with no maximum. Curiously, a bank retaining a large interest in its own securitization would have to have more capital than a bank that elects to hold the same assets on its books (I am not making this up). The proposal goes on to say that the aggregate of all retained interests in securitizations, combined with non-mortgage servicing rights and purchased credit card relationships, may not exceed 25 percent of Tier 1 capital.
The proposal defines a retained interest "as those on-balance sheet assets that represent interests (including beneficial interests) in the transferred financial assets retained by a seller (or transferor) after a securitization or other transfer of financial assets; and are structured to absorb more than a pro rata share of credit loss related to the transferred assets through subordination provisions or other credit enhancement techniques." Examples of residual interests include, but are not limited to, interest only strips receivable, excess servicing or spread accounts, cash collateral accounts, retained subordinated interests, and other similar forms of on-balance sheet assets that function as a credit enhancement. The proposal only applies to retained interests in a bank's own securitizations, not to purchases of a subordinated interest in another bank's securitization.
As the rule is presently written, both the dollar for dollar capital requirement and the 25 percent limitation would apply retroactively to existing retained interests. Fortunately, both the dollar for dollar capital requirement and the 25 percent of capital limitation on retained interests would be applied net of deferred tax liabilities.
Keep in mind that this is just a proposal. When the regulators publish this type of proposal they are seeking comments from the industry and from the public. Constructive comments on rule proposals often have considerable influence in shaping final rules. Comments on this proposal are due by December 26, 2000.
What Brought Us to this Point?
The proposed rule is the product of regulatory anxieties stemming from the "high-cost" failures of three banks which resulted in extremely high loss rates for FDIC's bank insurance fund, and recent examinations which have shown that a number of banks are not properly valuing their retained interests in securitizations.
The first "high-cost" bank failure was BestBank, a $300 million Colorado based sub-prime credit card lender, whose activities were marked by apparent fraud. The loss rate to the insurance fund exceeded 70 percent of the bank's assets. There was no indication BestBank was involved in securitization.
The next "high-cost" bank failure was the First National Bank of Keystone, West Virginia. FNB Keystone was a $1 billion FHA Title I, subprime and high LTV mortgage securitizer. Several of Keystone's senior executives engaged in fraud on a gigantic scale; half the bank's assets are still missing and unaccounted for. Losses to the insurance fund are expected to be between $750 and $850 million; the loss rate could be as high as 80 percent of total assets.
The third "high-cost" failure was Pacific Thrift and Loan which had $118 million in assets concentrated in subprime 1st and 2nd mortgages and $50 million in retained interests. The loss rate to the bank insurance fund is approximately 40 percent.
Loss rates of 40 to 80 percent are staggeringly high compared to the 12 percent average loss rate the FDIC had experienced in bank failures over the twenty years prior to the failure of BestBank.
In congressional testimony FDIC Chairman Donna Tanoue attributed this unusually high loss rate to FAS-125 gain-on-sale earnings which she identified as the source of "illusory capital" that permitted explosive growth and led to catastrophic losses. Under the present risk based capital rules gain-on-sale profits, however "illusory", do increase regulatory capital. The increase in capital, over and above the amount of capital currently required for retained interests, enables banks to reach the regulatory "well capitalized" threshold necessary to be allowed to access the brokered deposits market. The manager of a "well capitalized" bank can then increase deposit rates and purchase hundreds of millions of dollars of insured deposits with a couple of telephone calls to deposit brokers. Depositors do not care what the bank does with the money because the deposits are insured by the FDIC. In these circumstances the exposure of the FDIC's bank insurance fund can be enormous and provide the regulators with strong motivation to address the problem.
Objectives of the Proposed Rule
The proposed dollar for dollar capital requirement is designed to eliminate the capital leverage from gain-on-sale earnings. The 25 percent of capital limitation on the aggregate amount of retained interests is intended to limit concentrations in retained interests. The proposal clearly attempts to limit bank involvement in the types of securitizations that require in larger retained interests; e.g., subprime and high loan-to-value (high-LTV) mortgages, and loans to small businesses.
Discussions with regulators indicate the proposed rule is also designed to take smaller, less well-equipped, and less well diversified bank lenders out of the securitization business on the grounds that they are generally unable to manage the risks associated with securitization. The regulators think smaller banks are less able to cope with the earnings and capital volatility associated with properly valuing their retained interests, and with the losses the regulators expect to see in subprime and high LTV mortgages during an economic downturn.
If the proposed rule becomes final in its present form, minority and small business lending by banks will be reduced, and all but the largest banks will curtail their securitization activities and perhaps get out of securitization rather than pay the added costs imposed by the proposal. In the end, more credit business will be taken away from well-managed banks and the types of bankers causing the regulators problems will quickly find ways to circumvent the rules. In addition, I believe by limiting bank access to securitization the regulators will weaken the banking system.
The banks that will be hit the hardest by the proposal will be securitization driven subprime and high LTV mortgage lenders, and small business lenders.
Subprime and Minority Lending
The subprime market is larger today than any time since the 1930s and a large percentage of the subprime borrowers are minorities. In fact, a recent study released by the Association of Community Organizations for Reform Now (better known as ACORN) concluded that during the period 1995 to 1998 subprime loans made up 97% of the of the growth in conventional purchase mortgages to African-Americans and 45% of the increase to Latinos.
The regulators who were willing to talk about the impact of their proposal on minority lending expressed the view that bank regulation needs to be colored-blind. This attitude ignores the political and economic realities of today's credit markets.
Over the last two decades the regulators have pressured the banks to meet the credit needs of minority borrowers. Over this same period of time, the regulators have urged banks to price their loans to reflect the underlying risks. Bank subprime lenders are meeting the credit demand of minority borrowers and pricing their risks in a competitive marketplace. If the regulators make it more difficult for responsible banks to accommodate minority borrowers, competition in subprime lending will be reduced, the cost of credit to minority borrowers will go up, and predatory lenders will be left with a larger share of the market.
High LTV Lending, Taxes and Section 304 of the
FDIC Improvement Act
Banks engaged in high LTV lending are also meeting a legitimate credit demand from borrowers who seek lower cost, lower monthly payment, debt consolidation loans and/or the tax advantages associated residential mortgage borrowings.
Aggregate bank holdings of high LTV mortgages are already limited to 100 percent of capital by rules each bank regulatory agency wrote under Section 304 of the FDIC Improvement Act of 1991. Overall, the regulators have a very low opinion of high LTV lending. Many of them seem to see high LTV lending as fundamentally flawed. The rules limiting bank holdings of high LTV mortgages were written, and the regulatory attitudes toward high LTV mortgage lending were formed during the real estate/banking crises of the second half of the 1980s and early 1990s. Since then changes in the tax code have made high LTV mortgage borrowing considerably more attractive to consumers because the interest paid on residential mortgage loans is the principal form of interest paid on consumer debt that is still deductible from taxable income. Not surprisingly, borrowers would rather pay 8 or 9 percent (after taxes) on a high LTV home equity loan than 18 percent on a credit card. It is, however, surprising to me that the regulators still have rules in place that limit the availability of high LTV credit to prime borrowers and are proposing additional rules that will further limit the availability of high LTV mortgage credit regardless of the quality of the borrowers.
The tax and cost incentives associated with high LTV mortgages will assure a continuing consumer demand for this type of credit and the increased regulatory burden will assure that banks will be less able to meet this demand. The proposed increase in the regulatory burden will deprive well-managed banks of earnings opportunities and probably increase the cost of credit to consumers.
Small Business Lending
In the early 1990s congress passed legislation directing the bank regulators to permit well-capitalized banks to securitize a limited amount of loans to small businesses, retain recourse, and not have to provide capital for the recourse obligations. I participated in drafting the small business loan exemption and I think the dollar for dollar capital requirement in the proposed rule effectively nullifies the special exemption congress created for small business loan securitization.
The small business loan exemption was passed at a time when the bank regulators harshly (and in my opinion unjustly) criticized for pursuing supervisory policies that restricted credit availability to small business borrowers. You have to wonder why the regulators have exposed themselves to this charge once again.
Likely Circumvention of the Rule
Every time I discuss the proposed rule with people who are active in the securitization business they quickly think of ways to circumvent the rule. They don't do this because they are devious; they just see the proposed rule as pointlessly unfair to good managers.
The proposal will certainly encourage bank securitizers to consider modifying the way they do business in order to decrease the size of their on-balance sheet retained interests. In well managed banks this will probably mean a considerable sacrifice in earnings. In banks managed by type of people the regulators should worry about, adoption of the proposed rule will result in the employment of strategies that satisfy the requirements of the rule and may actually increase the risk to the institution and the FDIC's bank insurance fund.
In the end the bad managers will find ways to continue to be bad managers and the good managers will cut back on securitization because the proposed rule makes securitization less economical.
Outdated Regulatory Thinking Will Weaken the Banking System
By limiting bank access to the funding, earnings and diversification opportunities securitization makes available to small and medium sized banks the regulators are depriving them of the ability to use all the available tools to compete in today's marketplace. As the regulators make it more difficult for all but the largest banks to directly access the securitization markets the regulators are limiting the banks' survival options.
Bank securitization has flourished because of the fundamental unfairness of the current risk based capital system. Now at a time when regulators worldwide are proposing to introduce new elements of fairness into the risk based capital scheme the U. S. bank regulators have proposed the same old, already discredited, one size fits all regulatory approach for securitization. Any reasonable person would have to ask why the regulators are proposing to punish all the banks are because mismanagement and fraud led to high loss rates in three failed banks. This is bad regulation.
My recommendation to the regulators is to do the job of a supervisor. Forget the proposed rule and enforce the safety and soundness standards you already have. A series of recent enforcement actions clearly demonstrate the bank regulators have the ability to use their examination powers to ensure bank securitizers behave in a manner that does not threaten FDIC's insurance fund.
My recommendation to the industry is to encourage an independent group to develop standards of "best practice" for securitization. The securitization market is saddled with a grossly distorting accounting standard that drives participant behavior in some unhealthy directions. The bank regulators' new capital proposal may create more problems than it solves but the regulators have legitimate reasons to be concerned about securitization. There have been some very serious problems in the securitization market over the past few years and unless things change there will be more serious problems in the future. Widely accepted standards of "best practice" are the most effective means of discouraging the kinds of behavior that will give securitization another black-eye. Industry sponsorship of such an undertaking would preempt the regulators who are willing to set standards the industry may not be able to live with.
The classic model for the development of "best practice" standards in a complex and rapidly growing segment of the capital market is the Group of Thirty's 1993 derivatives market study. The series of recommendations that came out of this project enabled the derivatives market to avoid suffocating government regulation. A similar study of the securitization market would be more difficult because of the diversity among the types of market participants, but it can be done.