Almost nine years after it was originally contemplated, a notice of proposed rulemaking designed to revise the risk-based capital treatment of asset-backed and mortgage-backed securities was finally in the process of being approved by the four main federal banking agencies last week, sources said. A 90-day public comment period is to follow the proposal's imminent public release.

The Proposal to Revise the Risk-Based Capital Treatment of Recourse and Direct Credit Substitutes, set to go public within days, presents a ratings-based approach to risk weightings which would lower capital requirements on highly rated ABS (see chart on page 7) and offers alternate approaches for unrated direct credit substitutes, which are guarantees on a third party's assets.

By the week's end, sources close to the proposal said that each of the four agencies - the Department of the Treasury Office of the Comptroller of the Currency (OCC), the Federal Reserve System, the Federal Deposit Insurance Corporation (FDIC), and the Department of the Treasury Office of Thrift Supervision (OTS) - had approved the proposal in separate board meetings and were ready to present it for adoption.

"Our board met this afternoon and approved it, and now we are going to send it out for comment," said Robert F. Storch, the chief of the accounting section, division of supervision at the FDIC. "Based on comments from the August 1997 proposal, this time around we increased the number of risk weight categories. This proposal is really building upon the former one."

According to the proposal, banks and thrifts would only have to hold 20% risk-based capital against purchases of triple-A rated and double-A rated ABS paper. Currently, only Fannie Mae and Freddie Mac mortgage-backed securities enjoy this low capital requirement. The effect would be to reduce the capital requirement from 50% to 20% for highly rated private-label MBS.

The last time the proposal was floated was in 1997, and sources say that there were too many alternatives presented in that version for the proposal to be feasible or acceptable.

"The 1997 document presented broad approaches and broad alternatives, and it took a long time to hammer out the selection and refinement," said one federal source who wished to remain anonymous.

Additionally, after the 1997 proposal, Fannie Mae objected to having private-label securities treated the same as its MBS when the proposal was first put out nearly three years ago. A source from the OCC described this week's proposal as having a "much more pointed focus and presentation" than its predecessor.

"There were some concepts in the last notice of proposed rulemaking (1997) that were not fully formed it was more like an advance' notice of proposed rulemaking," said a source close to the current proposal. "For instance, in the 1997 version there were five different options for dealing with unrated direct credit substitutes that securitization banks generate. We had a lot of extremely technical comments on that and it took a long time to decide what alternatives would be workable for the industry and acceptable from a safety and soundness standpoint."

Private-Label MBS

Currently, the federal agencies assign privately-issued MBS to the 20% risk-weight category if the underlying pool is composed entirely of mortgage-related securities issued by Fannie Mae, Freddie Mac or Ginnie Mae. Privately-issued MBS backed by whole residential mortgages are now assigned to the 50% risk-weight category. The agencies propose to eliminate this "passthrough" treatment in favor of a ratings-based approach. Because most MBS usually also receive the highest or second highest credit rating, the agencies believe that "passthrough" treatment will be redundant once the ratings-based approach is implemented and, therefore, propose to eliminate it.

"The ratings-based approach will take away the advantages that agency mortgages have had for bank portfolios," said Art Frank, the head of mortgage research at Nomura Securities. "This, if it goes into effect, should, at least at the margin, widen agency mortgage spreads vis a vis other products, such as CMBS, ABS and corporates."

"The way things are now, institutions might feel that 100% risk-weightings, regardless of the ratings, are too high a capital charge for something that is triple-A rated," Storch added. "Whereas if and when the final rule takes effect, and it becomes a 20% risk weighting, they may feel that that capital charge is more in line with the kind of return they'd be getting in that type of investment, so there will be more bank purchases."

Under the latest proposal, triple-A and double-A ABS will have a 20% risk weighting, single-A will have 50%, triple-B, 100%, double-B, 200%, and B or lower securities (and unrated paper) will have "gross-up" treatment, meaning that a position is combined with all more senior positions in the transaction. The result is then risk-weighted based on the nature of the underlying assets.

As to how strongly this will affect an institution's attitude towards asset-backed securities, market observers said that largely depends on whether the risk-based or leverage capital ratio is the more constraining ratio for that particular institution. The leverage capital ratio requires a minimum of 4% Tier-1 capital against on-balance-sheet assets without any distinction between risk characteristics on individual assets.

Direct Credit Substitutes

Other notable sections of the proposal presents new approaches to deal with unrated direct credit substitutes, which an institution can choose to use if they satisfy the federal agencies that their use is appropriate.

For asset-backed commercial paper programs, for instance, an institution which has an internal risk-weighting system can use that to determine what its rating will be and how it will map to one of the nationally recognized agency ratings. In this way, the new proposal would permit the limited use of an institution's qualifying internal risk-rating system, a rating agency's or other appropriate third party's review of the credit risk of positions in structured program, or qualifying software to determine the capital requirements for certain unrated direct credit substitutes.

Subscribe Now

Access to a full range of industry content, analysis and expert commentary.

30-Day Free Trial

No credit card required. Access coverage of the securitization marketplace, including breaking news updated throughout the day.