Structured Finance & Securitization Update
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On December 15, 2009, the Federal Deposit Insurance Corporation (FDIC) approved the adoption of a final rule (the Final Rule) that amends its risk-based capital and advanced risk-based capital regulations in response to the recent changes in generally accepted accounting principles (GAAP) effected by Statements of Financial Accounting Standards Nos. 166 and 167 (the Modifications).1 The Federal Reserve Board, the Office of the Comptroller of the Currency (OCC) and the Office of Thrift Supervision (together with the FDIC, the Agencies) are expected to adopt substantially similar final rules shortly with respect to the banking organizations they regulate. The Final Rule will become effective 60 days after publication in the Federal Register, which is expected to occur after all of the Agencies have approved such rules.
The Modifications are effective for calendar year reporting enterprises beginning on January 1, 2010. Among other things, the Modifications remove the concept of “qualifying special purpose entity” from GAAP and alter the GAAP consolidation analysis, thereby subjecting to consolidation under GAAP many existing and future securitizations that are not currently required to be consolidated. Banking organizations are subject to increased regulatory capital requirements as a result of having to consolidate the assets in such securitizations. They may also need to establish allowances for loan and lease losses (ALLL) to cover such assets.
The Final Rule adopts, with modifications (discussed below) permitting an optional two-quarter delay and subsequent two-quarter phase-in, the Agencies’ proposed rule on the subject (Proposed Rule) issued in August 2009.2 Specifically, the Final Rule, like the Proposed Rule, provides no ongoing relief for increases in risk-based capital or leverage capital requirements that will result from assets in existing and future securitizations being brought on balance sheet as a result of the Modifications. As a consequence, banking organizations will generally have to keep both risk-based capital and leverage capital against such assets, regardless of the amount of credit risk on such assets that the banking organization has economically transferred through the securitization. (Thus, for example, under the Final Rule, a banking organization could be required to keep the same amount of risk-based capital and leverage capital against assets underlying an on-balance-sheet securitization in which it has economically transferred 95% of the assets’ credit risk as it would in an on-balance-sheet securitization in which it transferred only 5% of such risk.) This risk-insensitive treatment (which is inconsistent with how the Agencies assess capital against on-balance-sheet assets underlying synthetic securitizations pursuant to OCC Bulletin 99-43, Federal Reserve Board SR Letter 99-32 and subsequent releases) appears to have been prompted by the Agencies’ perception that, during the credit crisis, some banking organizations provided their securitizations credit support beyond their contractual obligations (implicit support). In fashioning the Final Rule, the Agencies were unresponsive to industry suggestions that implicit support could be addressed other than through a risk-insensitive, one-size-fits-all capital assessment, apparently because they fear that banking organizations might again be tempted to provide such support in future crises and they view such treatment as the only way of addressing this.
As in the Proposed Rule, the Final Rule also:
- eliminates existing provisions under which a banking organization that is required to consolidate an asset-backed commercial paper program (ABCP program) under GAAP is permitted to exclude the consolidated ABCP program assets from risk-weighted assets and instead assess the risk-based capital charge requirement against any contractual exposures of the organization that arise from the ABCP program; and
- provides a reservation of authority to permit the Agencies to require banking organizations to treat entities that are not consolidated under GAAP, as modified by the Modifications, as if they were consolidated for risk-based capital purposes, commensurate with the risk relationship of a banking organization to such an entity.
In eliminating the exclusion for assets in consolidated ABCP programs, the Agencies also appear to have rejected the request of some industry participants that, as an alternative, they be allowed early adoption of Basel II’s advanced approaches rules’ internal assessment approach (IAA) for the assets in such programs. Instead, it appears that use of the IAA will be limited exclusively to a banking organization’s exposures to off-balance-sheet ABCP programs. The reservation of authority to permit the Agencies to require consolidation when it is not required by GAAP, as modified by the Modifications, is, among other things, designed to deter attempts to evade the increased capital requirements resulting from the Modifications.
Optional Transitional Delay and Phase-In of Increased Capital Requirements Resulting from the Modifications
In the Proposed Rule, the Agencies requested comment on whether some phase-in of the increased capital requirements resulting from the Modifications was appropriate. Despite the request of some industry groups for more significant transitional relief, the Final Rule provides for only an optional two-quarter delay, followed by an optional two-quarter phase-in, of such requirements.
The optional delay and optional phase-in apply only to the Agencies’ risk-based capital requirements and not to the leverage capital requirement.
Under the optional transitional relief, for the first two quarters after the date (the implementation date) on which a banking organization implements the Modifications (such first two quarters, the exclusion period), including the two calendar quarter-end regulatory report dates within the exclusion period, the banking organization will be permitted to exclude from risk-weighted assets those assets that, as of the implementation date, are held by variable interest entities that the banking organization is required to consolidate as of the implementation date (the amount of the assets so excluded, the exclusion amount), provided that:
- the variable interest entities existed before the implementation date,
- the banking organization did not consolidate the variable interest entities on its balance sheet for quarter-end regulatory reporting dates before the implementation date, and
- the banking organization so excludes all such assets.
During the exclusion period, the banking organization may also exclude from risk-weighted assets those assets held by variable interest entities that are consolidated ABCP programs, provided that the banking organization:
- is the sponsor of the ABCP program,
- before the implementation date, consolidated the variable interest entity onto its balance sheet under GAAP for quarter-end regulatory report dates and excluded the entity’s assets from the banking organization’s risk-weighted assets, and
- chooses to so exclude all such assets.
A banking organization that elects to exclude assets in accordance with the preceding provisions may not, however, exclude from risk-weighted assets the assets of any variable interest entities to which the banking organization has provided recourse through implicit support.
As a result of the above, during the exclusion period, a banking organization would include in risk-weighted assets an amount equal to the risk-weighted assets it would have been required to calculate for its contractual exposures to these variable interest entities, including direct-credit substitutes, recourse obligations, residual interests, liquidity facilities, and loans, under the risk-based capital rules in effect before the implementation date. The Final Rule’s adopting release states that the Agencies expect banking organizations to calculate risk-weighted assets using methodology similar to the methodology used to calculate the risk weights of exposures to ABCP programs pursuant to the ABCP program assets exclusion.
For the third and fourth quarters after the implementation date (such two quarters, together, the phase-in period), including the two quarter-end regulatory report dates within the phase-in period, a banking organization that exercised the optional delay mechanism for the first two quarters (delay mechanism) will be permitted to exclude, from risk-weighted assets, 50% of the exclusion amount. Under no circumstances, however, may the banking organization include in risk-weighted assets an amount less than the aggregate risk-weighted assets it would have held on the basis of its contractual exposures to variable interest entities on the implementation date in the absence of a requirement that those entities be consolidated.
Transitional Relief for ALLL
Under current risk-based capital rules, the amount of ALLL that may be included in tier 2 capital is limited to 1.25% of gross risk-weighted assets. Notwithstanding that limitation, during the exclusion period, including the two calendar quarter-end regulatory report dates within the exclusion period, a banking organization that elects to take advantage of the delay mechanism described above for risk-weighted assets may also include without limit in tier 2 capital the full amount (the “inclusion amount”) of that portion of ALLL attributable to the assets it excludes pursuant to the risk-weighted assets delay mechanism.
If a banking organization avails itself of the risk-weighted assets delay mechanism and, as described in the preceding paragraph, includes the inclusion amount in tier 2 capital during the exclusion period, it will be permitted, during the phase-in period, including the two quarter-end regulatory report dates within the phase-in period, to include without limit in tier 2 capital 50% of the inclusion amount. The remaining 50% of the inclusion amount, together with that portion of ALLL not attributable to consolidated variable interest entities to which the risk-weighted assets delay mechanism applies, may be included in tier 2 capital subject to the 1.25% limit. A banking organization may not, however, include in regulatory capital, beyond the 1.25% limit, any portion of ALLL associated with assets of a variable interest entity to which the banking organization has provided implicit support.
If you have any questions about any of these items, please contact your Sidley Austin LLP relationship attorney.
1 The text of the Final Rule, as well as the related adopting release, is available at http://www.fdic.gov/news/board/DEC152009no2.pdf.
2 The link to the Proposed Rule in the Federal Register can be found at http://edocket.access.gpo.gov/2009/pdf/E9-21497.pdf. For a discussion of the Proposed Rule, please see our Client Update dated August 27, 2009 at http://www.sidley.com/sidleyupdates/Detail.aspx?news=4144.
Sidley’s Structured Finance and Securitization practice is one of the largest and most experienced in the world. Now numbering more than 200 worldwide, our securitization lawyers have advised clients since the earliest days of securitization, including during the creation of the mortgage-backed securities market in the 1970s, the asset-backed and commercial paper conduit markets in the 1980s and the commercial mortgage-backed securities market in the 1990s. Today, our securitization lawyers are actively engaged on behalf of our clients in forging new strategies and approaches to address the challenges facing the global financial markets and in helping our clients understand and manage the increasingly complex legal and regulatory landscape. Our work includes not only advising on new securitization and structured finance transactions, but also handling securitization restructuring and workouts.
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This Sidley Update has been prepared by Sidley Austin LLP for informational purposes only and does not constitute legal advice. This information is not intended to create, and receipt of it does not constitute, a lawyer-client relationship. Readers should not act upon this without seeking advice from professional advisers.
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