By Nichol Bakalar, vice president, asset-backed research strategist, and John Tierney, director of structured credit research, Deutsche Bank.For the third time in six years, the Federal Financial Institutions Examination Council1 (FFIEC) is publishing in the Federal Register a proposal to alter current risk based capital (RBC) requirements for banking organizations. We focus on aspects of the proposal that address securitization, including recourse obligations (e.g., retained interests and residuals), direct credit substitutes (e.g., standby letters of credit), and revolving transactions.
Timing is Still Uncertain
This proposal is a follow up to the proposal from November 1997 and includes elements similar to the Basle Committee risk based capital proposal that was released for public comment last June. The proposal will be out for a 90-day public comment period after it is published in the Federal Register within the next few weeks. While the proposed changes to risk based capital ratings have been in the works for 10 years and this is the third draft of a proposal to reach public eyes, we have not uncorked the champagne yet. Most of the proposal should receive a friendly reception, but certain aspects will be controversial, especially the treatment of revolving structures. In addition the election year could slow the process. The proposal would be enacted on a proactive basis if it results in a higher risk based capital charge (i.e., existing positions would be grandfahered). The ruling would apply retroactively only if it would lower the required risk based capital requirement for a particular transaction.
Major Features of the Proposal
Risk rationalization is the main focus for investors.
By far the most important mandate for investors is the rationalization of the risk weightings for securitized products. Currently, securitized asset owned by a US bank garners a 100% risk weighting regardless of the credit priority of the security. (The one exception is a retained first loss position, which is subject to the low-level recourse rule - see discussion below.) The current proposal would vary the capital requirements for positions in securitized transactions according to their relative risk exposure as defined by the ratings from a nationally recognized rating agency. In the case of a split rating the highest rating would be used. A rating downgrade or withdrawal could change the RBC requirement for a position.
In the table below we list the proposed changes and contrast these against the 1997 proposal and the Basle proposal from last year. Two things stand out. First, the modified gross-up option that was included in 1997 has been removed. Second, not surprisingly, the FFIEC proposal closely mirrors that of the BIS.
Among other provisions the proposal aims to eliminate the difference between the risk-based capital treatment of recourse obligations and direct credit substitutes. Recourse is defined as "the risk of credit loss that a banking organization retains in connection with the transfer of its assets". Examples of recourse would be a residual interest or a retained first loss position. Under current guidelines a recourse arrangement requires a bank to hold the lesser of the face amount of the recourse obligation or 100% RBC against the full transaction, i.e., a gross-up approach. This is known as the low-level recourse rule.
This contrasts with a direct credit substitute, which is defined as any third-party credit enhancement. Examples of third-party credit enhancement include a standby letter of credit for another bank's conduit or the purchase of a subordinate tranche from a securitization issued by another bank. A direct credit substitute requires a bank to hold RBC against only the face amount of the direct credit substitute, for example the face value of the subordinate bonds. To further clarify, a bank retaining a first loss class on its own deal would be subject to the low level recourse rule. But if it purchases a position with equivalent credit risk it would only hold capital against the face amount. Regulators have been struggling to eliminate this anomaly for nearly a decade now.
A second provision, also highlighted in the Basle proposal, deals with the sponsor of a revolving credit securitization with early amortization features, such as a credit card master trust. Currently issuers are required to hold 100% RBC against the retained seller's interest (the unsecuritized portion of the master trust that is held on the issuer's balance sheet. This uncertificated portion is pari pasu with the other series in the trust.) However, the FFIEC proposal argues that early amortization risk is a form of recourse. The view is that there has not been an effective transfer of risk, and that an early amortization event could pose liquidity problems. The proposal also recognizes that the risk of early amortization is relatively remote, and hence recommends holding 20% RBC against the securitized portion of the trust. The seller's interest would remain 100% risk weighted.
The proposal also permits banks to use internal credit rating systems for setting RBC requirements for unrated assets on a bank's balance sheet.
Implications if Implemented...
Positive impact on demand.
Revised RBC guidelines have been eagerly awaited for US banks for a long time. The impact of these guidelines, will in our opinion have a positive effect on AAA ABS spreads, in particular, but not as strong as if similar guidelines had been finalized in 1994 or even 1997. Today US banks are for the most part capital rich and therefore, driven in most respects by other factors in their investment decisions. Longer term, if this proposal is enacted it will provide a stabilizing influence on the ABS market if the capital position of US banks reverses itself.
Given the asset/liability framework of most banks, we anticipate that increased demand will be focused on floating-rate and shorter average life fixed-rate product in the three-year and under sector. The proposal would benefit CMBS as well as ABS, but with CMBS banks will have to weigh the risk based capital benefits against potential asset/liability mismatches.
Conduits may face some changes.
The role of the conduits at banks has increased dramatically over the past few years. These off-balance sheet facilities are used for warehousing receivables and also as arbitrage vehicles. Today conduits house most of the ABS/CMBS investments for US banks since this strategy requires no risk-based capital versus carrying the securities on balance sheet. The revision on RBC for direct credit substitutes would make bank-provided credit enhancement for conduits onerously expensive. If this occurs, we believe that surety bond providers will be able to fill the role efficiently.
Many US banks fund on balance sheet at LIBOR less a spread and fund in their conduits at LIBOR plus a spread. Therefore, in the case of rated securities, there is a possibility that positions could be moved onto the balance sheet rather than housed in a conduit facility since for highly rated securities the low RBC charge would allow banks to take advantage of balance sheet versus conduit funding. But we expect limited, if any movement of this sort to take place. Even if a strategic shift occurs it is not likely to alter the overall supply and demand picture for ABS.
Issuers of revolvers are sure to fight.
The change in treatment of revolving structures is bad news, particularly for credit card issuers but is not much of a surprise. The corporate analyst and rating agency analyst community has long recognized the risks associated with early amortization features on revolving structures and have incorporated this understanding into their analysis. If this rule goes into effect, we think given the well-capitalized nature of most US banks it will not pose a problem. The non-bank banks, such as MBNA and Capital One may have more difficulty with this requirement but at present would still maintain strong capital positions if this portion of the proposal were enacted. This point is likely to draw extensive debate and comment and could eventually be replaced by some other means, such as disclosure of vintage analysis to the investor community or a more extensive monitoring process.
Rush out to buy ABS? Probably not.
This time around we think the FFIEC proposal is likely to be adopted. But the timing is uncertain. Regulators have gone a long way to fix many of the problems with the previous proposal but controversy will persist especially with the guidelines for revolving structures. As the comment letters come in, we may get a better feel for whether banks and other constituents are ready to accept this proposal or fight for further changes. On top of that, Washington regulators may move more slowly in an election year and some pressure might crop up from other central banks that become disgruntled if the US regulators make changes before the Basle committee comes out with revised guidelines. Once this proposal goes through (as we think it will), it will be a positive development and will likely contribute to more stable demand for structured product over time. But as we mentioned before, the market impact is not likely to be as dramatic as it would have been a few years ago.
1 - FFIEC was established as an interagency body to develop uniform guidelines for the Federal Reserve, the Federal Deposit Insurance Corp., the National Credit Union Administration, the Office of the Comptroller for the Currency, and the Office of Thrift Supervision.