Having gotten an earful from Wall Street about a proposal that, if implemented, could massively increase financial institutions' regulatory obligations for any structured deal that fits under a broad umbrella category of "complex structured finance transactions" (CSFTs), five federal agencies announced earlier this month that they had greatly revised their proposed criteria.

However, the proposed new rules could still prove quite burdensome for underwriters of lower quality credits, such as some high yield bonds, credit derivatives and securities tied to special purpose vehicles (SPVs), bankers speculated. The Bond Market Association, for one, said it would be issuing an opinion statement as soon as the agencies begin a public comment period.

The Office of the Comptroller of the Currency, the Office of Thrift Supervision, the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corp. and the Securities and Exchange Commission are jointly issuing the proposed rules.

Among the changes in the revised proposals is a more clarified statement as to which deals are affected (thus, such long-established structured deals as MBS are exempted), as well as a more streamlined process for underwriter risk management. Yet few believe the battle will end here - expect more complaints from the Street about burdens caused by the revised proposals, one junk investor speculated.

Arduous process

The whole rule-making process has been long and arduous. The impetus for the new reforms came out of the post-Enron Corp. period, when lawmakers and regulators voiced concerns about the risk and misuse of such products as derivatives and SPVs. In May 2004, the five agencies issued an "interagency statement on sound practices concerning complex structured finance activities," which laid out some possible risk management strategies for financial institutions, with the intention of better managing any potential legal and reputational risks that could arise from complex structured deals.

The agencies then asked for public comments, and got them in spades. More than 40 responses came in from commercial and investment banks, trade associations, lawyers, accounting firms and consultants, most arguing that a number of the agencies' initial proposals were unacceptable.

The overall sentiment on the Street was that the proposals, as originally submitted, were both far too broad and far too burdensome on underwriters. "The proposed guidance could impose significant burdens on market participants and discourage innovation," said BMA president Micah Green at the time. "Unless the scope is clarified or narrowed, it will result in a system that leaves financial institutions bogged down in process and unable to focus on transactions that most warrant increased scrutiny."

And other respondents "argued that the initial statement, if implemented, would disrupt the market for legitimate structured finance products and place U.S. financial institutions at a competitive disadvantage," the agencies said in a recent statement.

Industry response

Financial institutions that responded to the proposals argued that the agencies' idea of "complex structured finance transactions" was simply too broad a category, which included a variety of structured deals that simply were not novel or complex at all, such as standard-issue MBS. The fear was that, should the initial statement become an enforceable set of regulations, banks would have to identify any deal involving an SPV, for example, or any structured deal with cross-border elements as an "elevated risk."

In the newly revised proposal, the agencies attempt to better identify what constitutes an "elevated risk CFST" - those securities that, for example, "lack economic or business purpose," "involve circular transfers of risk that lack economic structure or business purpose" or have "material economic terms that are inconsistent with market norms [e.g., deep in the money' options or historic rate rollovers]."

Banks also had complained the initial proposal suggested internal controls and risk management procedures that "were overly prescriptive and burdensome," the agencies said in their revised proposal statement. For example, under the original proposal, a financial institution would have to conduct extensive and time-consuming "pre-transaction reviews" of all complex structured deals, regardless of whatever role the bank played in the deal.

Banks also could be on the hook for conducting more extensive check-ups on customers. For example, the initial agency proposal had financial institutions responsible for confirming the validity of a customer's financial disclosures.

Not much has changed on that front. In the revised proposal, the agencies still warn that "institutions should not conclude that a transaction identified as being an elevated risk CSFT involves minimal or manageable risks solely because another financial institution will participate in the transaction, or because of the size or sophistication of the customer or counterparty."

(c) 2006 Asset Securitization Report and SourceMedia, Inc. All Rights Reserved.

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