The ending of the comment period last Wednesday on a proposal to revise the risk-based capital treatment of recourse and direct credit subsidies (MBSL, 2/14/00) could spell the end of a strong demand for agency securities, market observers warn.

"Fannie and Freddie had been privileged assets," said Art Frank, head of MBS research at Nomura Securities.

Under the current rule, Fannie Mae and Freddie Mac securities have held a 20% risk-weight, while non-agency paper - even triple-A rated paper - had a 50% risk weight. Commercial mortgage-backed securities, asset-backeds and corporates all had a 100% risk weight. The new rule places all securities rated double-A and higher on a level playing field - all at a 20% risk weight.

"And that is likely to diminish bank portfolio appetite for agencies," Frank said.

Frank said that the proposed rule appears likely to be made permanent, based on a favorable comment letter the Bond Market Association has written to the agencies responsible for the rule: the Office of the Comptroller of Currency, the Federal Deposit Insurance Corp., the Office of Thrift Supervision, and the Federal Reserve System.

"The adoption of this element of the proposals would not only apply risk weights to securitization positions that are more consistent with the actual credit risk they present, but would also align the capital requirements applicable to such positions with those presently applicable to other positions that present a similar credit risk profile," the letter states.

The Association's letter, written by its deputy general counsel, George Miller, says that while there are some things in the proposal that need to be tweaked, it is generally in favor of the proposal.

"The Association strongly encourages the agencies to bring to fruition its significant efforts to improve regulatory risk-based capital treatment of recourse obligations and direct credit subsidies in asset-backed securitization transactions," the letter concludes.

Other comments received also hold the proposal in a favorable light. "[The Association of Financial Guaranty Insurors] supports this interpretation because financial guaranty insurance is merely one of the various forms of credit enhancement that together result in the assigned rating of the obligation," states the letter from Financial Security Assurance Inc. on behalf of the AFGI. "All of these forms of credit enhancement are in fact used to bring the underlying asset-backed transaction to the investment-grade rating before the guaranty is applied."

"The most important element of this proposal is equalizing the risk-based capital treatment of recourse obligations and direct credit subsidies," writes the World Savings Bank from Oakland, Calif. "Allowing institutions to lower their overall risk-based capital requirements simply by utilizing types of credit enhancements that currently receive more favorable risk-based capital treatment than traditional recourse smacks of pre-FIRREA [Financial Institutions Reform, Recovery & Enforcement Act of 1989] capital practices and ultimately could lead to the same disastrous results."

The proposed rule change has been on and off the table numerous times since 1997, and the concerned parties are urging those creating the rule to make sure this time it is finally implemented.

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