WASHINGTON - Critics say federal regulators jumped the gun last week by proposing stricter capital requirements on retained interests from asset securitizations at the same time that another proposal, addressing the broader issue of asset sales with recourse, is being debated.
"It sounds like somebody hit the panic button," said Gilbert T. Schwartz, a partner with the Washington law firm Schwartz & Ballen. "They have come up with bifurcated proposals, one dealing with recourse and one dealing with residuals. It seems to me that they should be trying to deal with the issue of securitizations on a global basis, rather than piecemeal."
Regulators say their concern is that banks are assuming significant risk to make securitized loan pools attractive to investors. One of the ways they do this is by reducing investors' exposure to credit risk through recourse arrangements. Recourse effectively guarantees that if the pool of loans fails to perform as expected, someone other than the investor - typically the bank - will absorb all of the pool's losses up to a certain level.
The regulators' most recent proposal, released last week by the Federal Deposit Insurance Corp., addresses what they see as the most potentially dangerous form of recourse arrangement: retained interests - or residuals - that banks hold after a securitization. Other regulators are expected to sign off on the proposal in the next few weeks, with its release for public comment to follow.
In a securitization, a bank sells a pool of loans to investors, who in turn get the right to receive the income from those loans over a specified period. In holding residuals, the bank retains the right to a portion of the income from the loans, but the bank's claim on that income is subordinate to that of all other investors.
That means that the bank will be the first investor to suffer losses if, for instance, the loans in the pool default at a higher rate than expected. Banks book residuals as assets, but their actual value is difficult to determine because they carry a high risk of loss. An overestimation of their value can subject a bank to a sudden write-down if they go bad, something that regulators believe contributed to the collapse of Pacific Thrift and Loan in California and the First National Bank of Keystone in West Virginia in 1999.
Under the proposal issued last week banks would be required to hold risk-based capital against residuals, and would be barred from using such assets to satisfy more than 25% of their regulatory capital requirements. In some cases this would require banks to hold dollar-for-dollar capital against residual assets, raising howls from the industry.
Mixed in with the concern about the proposal's tactics was some puzzlement about why it was issued at all. In a comprehensive proposal last February, regulators set out to equalize the capital charges assessed on various recourse vehicles. This has led some observers to question why the industry should be subject to the added regulatory burden of conforming to two separate rules, when one might suffice.
There are various explanations of why the regulators have taken this approach.
Michael L. Brosnan, the Office of the Comptroller of the Currency's deputy comptroller for risk evaluation, said regulators had seen a problem and decided to fix it before it got worse.
"We decided to deal with this retained interest matter because it is a very specific problem. We have a well-developed concern about this. In some cases certain banks have very liberally estimated the cash flow from residuals, and that has caused problems," he said.
Others saw it as a more tactical move. The recourse proposal, which has been under consideration in various forms since 1990, received a barrage of negative comment letters.
"I think they realized that the recourse proposal may not be adopted," said Mr. Schwartz. "Somewhere somebody has made a decision that recourse in the form of these types of residuals are so risky that they have to take some action right now," he said.