National Bank Appeals Process:
Appeal of OCC's Interpretation of the Risk-Based Capital Treatment of Assigned Residual Interests in Asset Securitizations

Background

A bank formally appealed the OCC's interpretation of the risk-based capital treatment of assigned residual interests in asset securitizations.  Specifically, the bank appealed the supervisory office decision that the as­signment of a portion of the residual interest would not result in a lower capital charge for the bank on the re­course exposure created by those residuals.

The bank asserted that because the assigned residual interests share in the losses on the underlying loans sold into the securitization, the bank should be permit­ted to lower its total risk-weighted assets for risk-based capital purposes by a similar proportion.  The bank fur­ther indicated that the transferred portions of the re­siduals creating the recourse obligation to third parties is structured in a manner that assures a pro-rata shar­ing of all risk and losses.  In support of this contention, the bank refers to the glossary section of the March 1998 Call Report Instructions under the heading, "Sales of Assets for Risk-Based Capital Purposes" (p.  A-72) (http://www.fdic.gov/banknews/callrept/crinst/398gloss.pdf).  The instructions state the following:

"...if the risk retained by the seller is limited to some fixed percentage of any losses that might be incurred and there are no other provisions re­sulting in retention of risk, either directly or indi­rectly, by the seller, the maximum amount of pos­sible loss for which the selling bank is at risk (the stated percentage times the amount of assets to which the percentage applies) is subject to risk-based capital and reportable in Schedule RC-R and the remaining amount of the assets transferred would be treated as a sale that is not subject to the risk-based capital requirements. For example, a seller would treat a sale of $1,000,000 in assets, with a recourse provision that the seller and buyer proportionately share in losses incurred on a ten percent and 90 percent basis, and with no other retention of risk by the seller, as a $100,000 asset sale with recourse and a $900,000 sale not subject to risk-based capital".

Discussion

The OCC's interpretation was that the bank's assign­ment of a portion of its retained residual interest in securitization transactions should not result in a re­duction of the bank's overall level of required capital.  As a class, both the assigned and retained residual interests are wholly subordinate to the claims of cer­tificate holders, and there is no pro-rata loss sharing with those senior interests.  The bank has not suffi­ciently limited its losses to a fixed percentage of losses on the underlying loans.  Consequently, the full amount of underlying loans are considered sold with recourse, and should be included in the bank's calcu­lation of risk-weighted assets.

In order to appropriately resolve the issues identified in the appeal, it was essential that the ombudsman con­sider them in the context of on-going interagency capi­tal policy deliberations and the resolution of similar is­sues with other institutions.  An interagency working group was scheduled to review this issue at a meeting in March 1999.

Conclusion

Until such time as a joint interagency decision was reached on the underlying issues, the ombudsman opted to permit the bank to continue its current risk-based capital treatment.  The bank's treatment reduced the capi­tal requirement in proportion to the percentage of the residuals assigned to third parties and reached a consensus that conforms to the OCC's original interpreta­tion as conveyed to the bank.  This consensus reaffirms that when a bank retains risk of credit loss in connection with a transfer of assets, those assets must be included in the bank's calculation of risk-weighted assets, subject to the low-level recourse rule.  Notwithstanding the assignment of a portion of a residual interest in a securitization, the re­tained residual interest continues to give rise to a concen­tration of credit risk, relative to the underlying pool, for which the recourse capital requirement remains appropriate.

Consequently, for each pool of securitized loans, the banks should hold risk-based capital equal to the lesser of (a) 8 percent of the risk weighted amounts of the outstanding loans in the pool, or (b) the bank's maximum loss in the event the entire pool of loans defaulted.  For this purpose, the bank's maximum loss exposure includes the book value (determined under GAAP) of any interest it holds in the pool, as well as any contractual obligation to reimburse the pool or investors for losses in the pool.  If the bank's maximum loss exposure exceeds 8 percent of a pool's risk-weighted assets, the full amount of the underlying loans are consid­ered sold with recourse and should be included in the bank's calculation of risk-weighted assets.  However, should the bank's maximum loss exposure fall below 8 percent of the risk-weighted amount of the outstanding loan balances in the pool, the position would be eligible for more advanta­geous treatment under the low-level recourse rule.

The bank was informed of this decision.

The bank was to be informed when the agencies reached a final decision, and of any risk-based capital adjust­ments, which The Federal Reserve Board, the Federal Deposit Insurance Corporation, the Office of Thrift Supervision, and the OCC reviewed this policy issue in March 1999, may be necessary.

Subsequent Event

The Federal Reserve Board, the Federal Deposit Insurance Corporation, the Office of Thrift Supervision, the OCC reviewed this policy issue in March 1999, and reached a consensus that conforms to the OCC's original interpretation as conveyed to the bank.  This consensus reaffirms that when a bank retains risk of credit loss in connection with a transfer of assets, those assets must be included in the bank's calculation of risk-weighted assets, subject to the low-level recourse rule.  Notwithstanding the assignment of a portion of a residual interest in a securitization, the retained residual interest continues to give rise to a concentration of credit risk, relative to the underlying pool, for which the recourse capital requirement remains appropriate.

Consequently, for each pool of securitized loans, the banks should hold risk-based capital equal to the lesser of (a) 8 percent of the risk weighted amounts of the outstanding loans in the pool, or (b) the bank's maximum loss in the event the entire pool of loans defaulted.  For this purpose, the bank's maximum loss exposure includes the book value (determined under GAAP) of any interest it holds in the pool, as well as any contractual obligation to reimburse the pool or investors for losses in the pool.  If the bank's maximum loss exposure exceeds 8 percent of a pool's risk-weighted assets, the full amount of the underlying loans are considered sold with recourse and should be included in the bank's calculation of risk-weighted assets.  However, should the bank's maximum loss exposure fall below 8 percent of the risk-weighted amount of the outstanding loan balances in the pool, the position would be eligible for more advantageous treatment under the low-level recourse rule.

The bank was informed of this decision.