In the last 10 years, securitization of short- and medium-term assets has become a common tool of commercial finance.

Just a minor source of finance before 1985, explosive growth in asset securitization began in that year when Salomon Brothers securitized Marine Midland Banks' automobile loans and leases in the first public offering of asset-backed securities. The asset-backed market was responsible for over $75 billion in newly issued securities in 1994 and $45.8 billion in securities in the first half of 1995.

The development of asset-backed securities markets can be attributed to their success in serving many masters well. For would-be borrowers, asset- backed securities represent access to the world's most efficient sources of U.S. dollar capital - the U.S. and Eurodollar capital markets.

For investment bankers, the development of asset-backed securities has been a natural extension of the mortgage-backed securities products developed over the last 25 years.

But perhaps the greatest force driving asset-backed securities markets has been commercial banks. Asset-backed securities have given commercial banks the opportunity to generate commercial loans by leveraging their capital to exponentially greater levels than available in conventional loans or other extensions of credit.

Billions of dollars of asset-backed securities have been created under commercial bank sponsorship, enabling banks to offer capital markets financing to their traditional commercial loan customer base. In the process, sponsoring banks have converted loan asset income into fee income, leveraged capital income, and in some cases, both.

Much of the innovation in asset-backed securities programs was motivated by the desire of commercial banks to remove loan assets from their balance sheets while maintaining income from those loan relationships. This motivation was a response to federal bank regulators' requirements developed during the last decade that banks increase their capital ratios (i.e., the ratio of equity capital to a bank's assets).

Requirements were imposed in response to the federal regulators' judgment that insufficient levels of bank capital threatened the overall stability of the financial system.

Early asset securitization programs involved direct sales of a customer's loan assets by a bank to a securitization "conduit," with the selling bank maintaining a level of credit recourse or providing some other form of credit enhancement. Financial Accounting Standard No. 77 permitted a selling bank to remove the assets sold from its balance sheet under generally accepted accounting principles, thereby shrinking the selling bank's asset size and improving its capital ratio.

Federal regulators, however, concluded that the risk retained by a selling bank was effectively all of the real credit risk in the transaction. Accordingly, federal regulators refused to permit banks selling assets in securitization transactions with even limited recourse to treat those securitization transactions as sales under regulatory accounting principles.

The bankers' problem remained. Under federal banking regulations, making loans required capital to be maintained at 8% of the loan assets. The cost of this capital could not be passed onto the bank's best customers because of competitive loan pricing from other banks, finance companies, and other sources of financing.

Asset securitization solved the bankers' problem: securitization gave bank sponsors a source of fee income while offering their customers a competitive source of credit. The fee income was derived from the administrative and program management services provided by the commercial bank's organization and management of its customer's securitization. Since this fee income did not put the bank's capital at risk, no capital reserve was required under federal banking regulations for a bank to act as a sponsor.

The attractiveness of fee income as a alternative to more capital- intensive loan income propelled commercial banks to develop asset-backed securities programs. These programs are now widely utilized by money center, regional, and foreign bank sponsors to provide financing for their customers. In these programs, the bank sponsor does not make a direct loan which could be sold or refinanced in a securitization, but to facilitate the transaction, the bank sponsor may provide short-term liquidity and limited credit enhancement structured in a way to minimize the sponsor's capital requirements for regulatory accounting purposes.

The sponsoring bank effectively leverages its capital for its customer using the securitization, utilizing capital to support only its limited credit enhancement.

In 1990 the federal regulators, through their coordinating body, the Federal Financial Institutions Examination Council began to focus on banks' use of asset securitization programs to leverage capital. The federal banking agencies have become concerned that bank credit enhancement of asset-backed securities is, in substance, the equivalent of a direct recourse arrangement by the enhancing bank and should be subject to the same capital treatment as direct recourse sales of assets by banks.

On May 25, 1994, the FFIEC proposed rules for the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corp., the Federal Reserve Board, and the Office of Thrift Supervision which would, in effect, require financial institutions regulated by those agencies to treat common forms of capital leveraging through credit enhancement in asset securitizations as subject to a "full, effective risk-based capital charge" (i.e., 8% of the total principal or face amount of asset-backed securities issued, regardless of the actual level of credit enhancement of those securities).

The FFEIC received extensive comments to its proposed rules and has taken no action since the comment period closed in July 1994. While federal bank regulators have stated formally that the proposed capital rules currently remain under consideration, the lapse of time since the proposed rulemaking has created some skepticism.

For now at least, asset securitization remains an effective tool for commercial banks to offer their customers a competitive credit product. Banks can generate fee income and leverage their capital to produce better returns on capital for their credit commitments. While this remains a highly competitive business, with very aggressive pricing,3 it does provide an "anchor" which gives the bank sponsor the ability to cross sell other services to its customers.

Mr. Aidun is a partner in the New York law firm of Loeb & Loeb. This article is based on a fuller discussion of asset securitization to appear in the September issue of Robert Morris Associates' Journal of Commercial Lending.

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