A. Basis of Current RiskBased Capital Rules

Since the late 1980s, the regulatory capital requirements applicable to federally regulated financial institutions, including FCS institutions, have been based, in part, on the riskbased capital framework developed under the guidance of the Basel Committee on Banking Supervision (Basel Committee).\2\ We first adopted risk weighting categories for System assets as part of the 1988 regulatory capital revisions \3\ required by the Agricultural Credit Act of 1987 \4\ and made minor revisions to these categories in 1998.\5\ Risk weighting is used to assign on and offbalance sheet positions appropriate capital requirements and to compute the riskadjusted asset base for FCS banks' and associations' permanent capital, core surplus, and total surplus ratios. The current riskweighting categories are similar to those outlined in the Accord on International Convergence of Capital Measurement and Capital Standards (1988, as amended in 1998) (Basel Accord), which were also adopted by the other financial regulatory agencies. Our riskbased capital requirements are contained in subparts H and K of part 615 of our regulations.
\2\ The Basel Committee is a committee of central banks and bank supervisors/regulators from the major industrialized countries that formulate standards and guidelines related to banking and recommend them for adoption by member countries and others. All Basel Committee documents mentioned in this preamble are available on the Committee's Web site at http://www.bis.org/bcbs/. \3\ See 53 FR 39229 (October 6, 1988).
\4\ Agricultural Credit Act of 1987, Pub. L. 100233 (January 6, 1988).
\5\ See 63 FR 39219 (July 22, 1998).

B. Implications of the New Basel Capital Accord

In April 2003, the Basel Committee issued a consultative document on the proposed New Basel Capital Accord (Basel II). Basel II discusses potential modifications to the current Basel Accord, including the capital treatment of securitizations. The standards established by our proposal enhance risk sensitivity in a manner consistent with the standardized approach to credit risk under Basel II. The standardized approach establishes fixed risk weights corresponding to each supervisory risk weight category and makes use of external credit assessments to enhance risk sensitivity compared with the current Basel Accord. Similarly, under our proposal we use external credit ratings assigned by NRSROs as a basis for determining the credit quality and the resulting capital treatment for credit exposures.\6\ According to their most recent press release (May 11, 2004), the Basel Committee has achieved consensus on the remaining issues regarding the proposals for the new international capital standard. The Basel Committee also confirmed that the standardized and foundation approaches will be implemented from yearend 2006. However, the Committee indicated that another year of impact analysis will be needed to evaluate the most advanced approaches, and therefore these will not be implemented until yearend 2007. As we continue to review Basel II and assess its implications and appropriateness for FCS institutions, we may make further revisions to our capital regulations. In the interim, we welcome comments on the proposed
[[Page 47985]]
new framework and its applicability to FCS institutions.
\6\ An NRSRO is a rating organization that the Securities and Exchange Commission recognizes as an NRSRO. See 12 CFR 615.5131(j). See also 66 FR 59632, 59639, 59655, 59662 (November 29, 2001). C. Rules Recently Adopted by the Other Financial Regulatory Agencies

In developing these proposed changes, we also took into consideration recent changes the other financial regulatory agencies made to their capital rules. These changes are briefly described below.

In November 2001, the other financial regulatory agencies issued a final rule that amended their riskbased capital regulations for positions that banking organizations \7\ hold in recourse obligations, direct credit substitutes, residual interests, and asset and mortgage backed securities.\8\ The other financial regulatory agencies intended for these changes to produce more consistent capital treatment for credit risks associated with exposures arising from these positions. More specifically, the new riskbased standards tie capital requirements for these transactions to their relative risk exposure, as measured by credit ratings received from an NRSRO.
\7\ Banking organizations include banks, bank holding companies, and thrifts. See 66 FR 59614 (November 29, 2001).

\8\ See 66 FR 59614 (November 29, 2001).

Similarly, in April 2002, the other financial regulatory agencies, consistent with the proposed changes to the Basel Accord, issued a rule that amended their riskbased capital standards for banking organizations with regard to the risk weighting of claims on, and claims guaranteed by, qualifying securities firms.\9\ The capital requirements for these claims are also tied in a similar manner to their relative risk exposure as measured by NRSRO credit ratings. \9\ See 67 FR 16971 (April 9, 2002).

In January 2002, the other financial regulatory agencies (except the OTS) adopted a joint final rule governing the regulatory capital treatment of equity investments in nonfinancial companies held by banking organizations under various legal authorities.\10\ Among other changes in regulatory capital treatment, this joint final rule addresses the risk weighting of investments in small business investment companies (SBICs).

\10\ See 67 FR 3784 (January 25, 2002).

In August 2003, the other financial regulatory agencies issued for comment their views on the proposed framework for implementing the Basel II in the United States.\11\ The advance notice of proposed rulemaking (ANPRM) describes significant elements of the Advanced Internal RatingsBased approach for credit risk (including credit exposures from securitizations) and the Advanced Measurement Approaches for operational risk. The ANPRM also specifies the criteria that would be used to determine banking organizations that would be required to use the advanced approaches.\12\
\11\ See 68 FR 45900 (August 4, 2003).
\12\ Internationally active banking organizations with total assets of $250 billion or more or total onbalance sheet foreign exposures of $10 billion or more would be required to adopt the advanced approaches. All other banks would continue to apply the general riskbased capital rules, unless they optin.

Our proposal does not address the advanced approach for positions in securitizations (or any other credit exposures). The focus of this proposed rule is on improving the risk sensitivity of the current risk based capital through the use of external credit ratings.

D. FCA Rulemakings

On February 19, 2003, the FCA Board adopted an interim final rule that amended our capital rules to allow System institutions to use a lower risk weighting for highly rated investments in nonagency \13\ assetbacked securities (ABS) and mortgagebacked securities (MBS), which have reduced exposure to credit risk.\14\ This was one of the changes the other financial regulatory agencies made in November 2001. Because this change was narrow and noncontroversial, relieved a regulatory burden, and immediately furthered the mission of the System, we adopted it without prepromulgation comment. This change became effective on May 13, 2003. We issued the interim final rule with a request for comments but received none.
\13\ Nonagency securities are securities not issued or guaranteed by the United States Government, a Government agency (as defined in Sec. 615.5201(f)), or a Governmentsponsored agency (as defined in Sec. 615.5201(g)).

\14\ See 68 FR 15045 (March 28, 2003).

Additionally, on April 22, 2004, FCA adopted changes to the risk based capital treatment for other financing institutions (OFIs).\15\ Those amendments also aimed to enhance the risk sensitivity of FCA's riskbased capital rules through changes in risk weightings. This proposed rule incorporates the changes made to our risk weightings through the OFI rulemaking.
\15\ See 69 FR 29852 (May 26, 2004).

E. GAO Recommendation on Capital Arbitrage

In a recent report, the GAO recommended that the FCA ``[c]reate a plan to implement actions currently under consideration to reduce potential safety and soundness issues that may arise from capital arbitrage activities of Farmer Mac and FCS institutions.'' \16\ This proposed rulemaking takes important steps to reduce potential safety and soundness issues that may result from securitization and guarantee/ credit protection arrangements that FCS institutions engage in with the Federal Agricultural Mortgage Corporation (Farmer Mac), domestic banks, and securities firms. In particular, we take measures to ensure that FCS institutions cannot alter their capital requirements simply by using different structures, arrangements or counterparties without changing the nature of the risks they assume or retain.
\16\ United States General Accounting Office, Farmer Mac: Some Progress Made, but Greater Attention to Risk Management, Mission, and Corporate Governance Is Needed, GAO04116, at page 59 (2003). III. Scope of Our Proposal

Our proposal embraces many of the Basel Committee's objectives for improving risk sensitivity in regulatory capital rules and aligns our riskbased capital framework closely with the rules of the other financial regulatory agencies. However, because the scope of the FCS institutions' activities differs from the activities of banking organizations, our proposal is not identical to their rules. Their rules focus on traditional securitization activities, where a banking organization sells assets or credit exposures to increase its liquidity and manage credit risk. Our proposal places more emphasis on capital treatment of investments in ABS and MBS held for liquidity and other types of structured financial transactions and arrangements where an FCS institution transfers, retains, or assumes credit risk to manage its credit risk profile. Examples of these other types of transactions and arrangements are synthetic securitizations, financial guarantee arrangements, longterm standby purchase commitments, and credit derivatives.

Like the other financial regulatory agencies, we are also proposing a ratingsbased approach for claims on securities firms. Additionally, similar to the rules that the other financial regulatory agencies have adopted, our proposal also addresses risk weighting for authorized investments in nonfinancial companies. Subtitle H of the Consolidated Farm and Rural Development Act,\17\ as amended by section 6029 of the Farm Security and Rural Investment Act of 2002,\18\ authorizes System institutions to invest in rural business investment companies (RBICs). RBICs are similar to SBICs, in
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which banking organizations are allowed to invest.
\17\ Pub. L. 87128 (August 8, 1961).

\18\ Pub. L. 107171 (May 3, 2002).

Furthermore, as the other financial regulatory agencies have done, we are making explicit our authority to modify a stated risk weight or credit conversion factor, if warranted, on a casebycase basis.

We invite comments on whether we should make any additional modifications to our riskbased capital rules to more closely align capital requirements for FCS institutions with their relative risk exposure and requirements for other banking organizations. We also invite comments on whether FCA should delay or accelerate
implementation of any aspects of this proposal.
IV. Overview

A. General Approach

We propose revisions to our capital rules that would implement a ratingsbased approach for riskweighting positions in recourse obligations, residual interests (other than creditenhancing interest only strips), direct credit substitutes, and asset and mortgagebacked securities. Highly rated positions will receive a favorable (less than 100percent) risk weighting. Positions that are rated below investment grade \19\ will receive a less favorable risk weighting (generally greater than 100percent risk weight). The FCA proposes to apply this approach to positions based on their inherent risks rather than how they might be characterized or labeled.
\19\ Investment grade means a credit rating of AAA, AA, A or BBB or equivalent by an NRSRO.

As noted, our proposed ratingsbased approach provides risk weightings for a variety of assets that have a wide range of credit ratings. We provide risk weightings for investments that are rated below investment grade, although they are not eligible investments under our current investment regulations.\20\ This proposed rule does not, however, expand the scope of eligible investments. It merely explains how to risk weight an investment that was eligible when purchased if its credit rating subsequently deteriorates. Such investments must still be disposed of in accordance with Sec. 615.5143.\21\
\20\ See Sec. 615.5140.
\21\ Section 615.5143 provides that an institution must dispose of an ineligible investment within 6 months unless FCA approves, in writing, a plan that authorizes divestiture over a longer period of time. An institution must dispose of an ineligible investment as quickly as possible without substantial financial loss.

B. Asset Securitization

This proposal necessitates an understanding of asset securitization and other structured transactions that are used as tools to manage and transfer credit risk. Therefore, we have included the following background explanation to aid our readers.

Asset securitization is the process by which loans or other credit exposures are pooled and reconstituted into securities, with one or more classes or positions that may then be sold. Securitization provides an efficient mechanism for institutions to sell loan assets or credit exposures and thereby to increase the institution's liquidity. For purposes of this preamble, references to ``securitizations'' also include structured financial transactions or arrangements and synthetic transactions \22\ that generally create stratified credit risk positions, which may or may not be in the form of a security, whose performance is dependent upon a pool of loans or other credit exposures. For example, in a synthetic securitization, loans are not sold or transferred, but rather the performance of securities is tied to a reference pool of loan assets or other credit exposures.\23\ \22\ For examples of synthetic securitization structures, see Banking Bulletin 9943, December 1999 (OCC); Supervision and Regulation Letter 9932, Capital Treatment for Synthetic
Collateralized Loan Obligations, November 15, 1999 (Federal Reserve Board).
\23\ Synthetic transactions bundle credit risks associated with onbalance sheet assets or offbalance sheet items and sell them into the market.

Securitizations typically carve up the risk of credit losses from the underlying assets and distribute it to different parties. The ``first dollar,'' or most subordinate, loss position is first to absorb credit losses; the most ``senior'' investor position is last to absorb losses; and there may be one or more loss positions in between (``second dollar'' loss positions). Each loss position functions as a credit enhancement for the more senior positions in the structure.

Recourse, in connection with sales of whole loans or loan participations, is now frequently associated with asset
securitizations. Depending on the type of securitization, the sponsor of a securitization may provide a portion of the total credit enhancement internally, as part of the securitization structure, through the use of excess spread accounts, overcollateralization, retained subordinated interests, or other similar onbalance sheet assets. When these or other onbalance sheet internal enhancements are provided, the enhancements are ``residual interests'' for regulatory capital purposes.

A seller may also arrange for a third party to provide credit enhancement \24\ in an asset securitization. If another financial institution provides the thirdparty enhancement, then that institution assumes some portion of the assets' credit risk. In this proposed rule, all forms of thirdparty enhancements, i.e., all arrangements in which an FCS institution assumes credit risk from thirdparty assets or other claims that it has not transferred, are referred to as ``direct credit substitutes.''
\24\ The terms ``credit enhancement'' and ``enhancement'' refer to both recourse arrangements (including residual interests) and direct credit substitutes.

Many asset securitizations use a combination of recourse and third party enhancements to protect investors from credit risk. When third party enhancements are not provided, the institution ordinarily retains virtually all of the credit risk on the assets.

C. Risk Management

While asset securitization can enhance both credit availability and profitability, managing the risks associated with this activity poses significant challenges. While not new to FCS institutions, these risks may be less obvious and more complex than traditional lending activities. Specifically, securitization can involve credit, liquidity, operational, legal, and reputation risks that may not be fully recognized by management or adequately incorporated into risk management systems. The capital treatment required by this proposed rule addresses credit risk presented in securitizations and other credit risk mitigation techniques. Therefore, it is essential that an institution's compliance with capital standards be complemented by effective risk management practices and strategies.

Similar to the other financial regulatory agencies, the FCA expects FCS institutions to identify, measure, monitor, and control securitization risks and explicitly incorporate the full range of those risks into their risk management systems. The board and management are responsible for adequate policies and procedures that address the economic substance of their activities and fully recognize and ensure appropriate management of related risks. Additionally, FCS institutions must be able to measure and manage their risk exposure from securitized positions, either retained or acquired. The formality and
sophistication with which the risks of these activities are [[Page 47987]]
incorporated into an institution's risk management system should be commensurate with the nature and volume of its securitization activities.\25\
\25\ This proposal would not grant any new authorities to System institutions. It merely provides risk weightings for investments and transactions that are otherwise authorized.

V. SectionbySection Analysis of Proposed Changes

The following discussion provides explanations, where necessary, of the more complex changes we propose. Most of the changes are necessary to more closely align our rules with those of the other financial regulatory agencies and to recognize relative risk exposure. As mentioned above, we have also made a number of organizational and plain language changes to make our rules easier to follow. These changes are discussed later in this preamble.

A. Section 615.5201Definitions

Because this rule would implement a new riskweighting approach for recourse obligations, residual interests, direct credit substitutes, and other securitization and guarantee arrangements, we are proposing to amend Sec. 615.5201 to add a number of new definitions relating to these activities. We are also proposing to update certain other definitions as warranted. For the most part, to achieve consistency with the other financial regulatory agencies, we are proposing to adopt the same definitions as the other agencies.

1. Credit Derivative

We propose to define credit derivative as a contract that allows one party (the protection purchaser) to transfer the credit risk of an asset or offbalance sheet credit exposure to another party (the protection provider). The value of a credit derivative is dependent, at least in part, on the credit performance of a ``reference asset.''

The proposed definitions of ``recourse'' and ``direct credit substitute'' cover credit derivatives to the extent that an institution's credit risk exposure exceeds its pro rata interest in the underlying obligation. The ratingsbased approach therefore applies to rated instruments such as creditlinked notes issued as part of a synthetic securitization.

Credit derivatives can have a variety of structures. Therefore, we will continue to evaluate credit derivatives on a casebycase basis. Furthermore, we will continue to use the December 1999 guidance on synthetic securitizations issued by the Federal Reserve Board and the OCC as a guide for determining appropriate capital requirements for FCS institutions and continue to apply the structural and risk management requirements outline in the 1999 guidance.\26\
\26\ See Banking Bulletin 9943, December 1999 (OCC);
Supervision and Regulation Letter 9932, Capital Treatment for Synthetic Collateralized Loan Obligations, November 15, 1999 (Federal Reserve Board).

2. CreditEnhancing InterestOnly Strip

We propose to define the term ``creditenhancing interestonly strip'' as an onbalance sheet asset that, in form or in substance, (1) Represents the contractual right to receive some or all of the interest due on transferred assets; and (2) exposes the institution to credit risk directly or indirectly associated with the transferred assets that exceeds its pro rata claim on the assets, whether through subordination provisions or other credit enhancement techniques. FCA proposes to reserve the right to identify other cash flows or related interests as creditenhancing interestonly strips based on the economic substance of the transaction.

Creditenhancing interestonly strips include any balance sheet asset that represents the contractual right to receive some or all of the remaining interest cash flow generated from assets that have been transferred into a trust (or other special purpose entity), after taking into account trustee and other administrative expenses, interest payments to investors, servicing fees, and reimbursements to investors for losses attributable to the beneficial interests they hold, as well as reinvestment income and ancillary revenues \27\ on the transferred assets.
\27\ According to the Statement of Financial Accounting Standards No. 140, ancillary revenues include late charges on transferred assets.

Creditenhancing interestonly strips are generally carried on the balance sheet at the present value of the reasonably expected net cash flow, adjusted for some level of prepayments if relevant, and discounted at an appropriate market interest rate. Typically, transfers of assets accounted for as a sale under generally accepted accounting principles (GAAP) result in the seller recording a gain on the portion of the transferred assets that has been sold. This gain is recognized as income, thus increasing the institution's capital position.

Under the proposed rule, FCA would look to the economic substance of the transaction and reserve the right to identify other cash flows or spreadrelated assets as creditenhancing interestonly strips on a casebycase basis. For example, including some principal payments with interest and fee cash flows will not otherwise negate the regulatory capital treatment of that asset as a creditenhancing interestonly strip. Creditenhancing interestonly strips include both purchased and retained interestonly strips that serve in a creditenhancing capacity, even though purchased interestonly strips generally do not result in the creation of capital on the purchaser's balance sheet. 3. CreditEnhancing Representations and Warranties

When an institution transfers or purchases assets, including servicing rights, it customarily makes or receives representations and warranties concerning those assets. These representations and warranties give certain rights to other parties and impose obligations upon the seller or servicer of those assets. To the extent such representations and warranties function as credit enhancements to protect asset purchasers or investors from credit risk, the proposed rule treats them as recourse or direct credit substitutes.

More specifically, creditenhancing representations and warranties are defined in the proposal as representations and warranties that: (1) Are made or assumed in connection with a transfer of assets (including loanservicing assets); and (2) obligate an institution to protect investors from losses arising from credit risk in the assets transferred or loans serviced. As proposed, the term includes promises to protect a party from losses resulting from the default or nonperformance of another party or from an insufficiency in the value of collateral.

The proposed definition is consistent with the other financial regulatory agencies' longstanding recourse treatment of
representations and warranties that effectively guarantee performance or credit quality of transferred loans. However, a number of factual warranties unrelated to ongoing performance or credit quality are typically made. These warranties entail operational risk, as opposed to credit risk inherent in a financial guaranty, and are excluded from the definitions of recourse and direct credit substitute. Warranties that create operational risk include warranties that assets have been underwritten or collateral appraised in conformity with identified standards and warranties that permit the return of assets in instances of incomplete documentation, misrepresentation, or fraud. FCA expects FCS institutions to be able to demonstrate effective management of operational risks created by warranties.

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Warranties or assurances that are treated as recourse or direct credit substitutes include warranties on the actual value of asset collateral or that ensure the market value corresponds to appraised value or the appraised value will be realized in the event of foreclosure and sale. Also, premium refund clauses, which can be triggered by defaults, are generally credit enhancements. A premium refund clause is a warranty that obligates the seller who has sold a loan at a price in excess of par, i.e., at a premium, to refund the premium, either in whole or in part, if the loan defaults or is prepaid within a certain period of time. However, certain premium refund clauses are not considered credit enhancements, including:
(1) Premium refund clauses covering loans for a period not to exceed 120 days from the date of transfer. These warranties may cover only those loans that were originated within 1 year of the date of the transfer; and
(2) Premium refund clauses covering assets guaranteed, in whole or in part, by the United States Government, a United States Government agency, or a United States Governmentsponsored agency, provided the premium refund clause is for a period not to exceed 120 days from the date of transfer.

Cleanup calls, an option that permits a servicer or its affiliate to take investors out of their positions prior to repayment of all loans, are also generally treated as credit enhancements. A cleanup call is not recourse or a direct credit substitute only if the agreement to repurchase is limited to 10 percent or less of the original pool balance. Repurchase of any loans 30 days or more past due would invalidate this exemption.

Similarly, a loanservicing arrangement is considered as recourse or a direct credit substitute if the institution, as servicer, is responsible for credit losses associated with the serviced loans. However, a cash advance made by a servicer to ensure an uninterrupted flow of payments to investors or the timely collection of the loans is specifically excluded from the definitions of recourse and direct credit substitute, provided that the servicer is entitled to reimbursement for any significant advances and this reimbursement is not subordinate to other claims. To be excluded from recourse and direct credit substitute treatment, an independent credit assessment of the likelihood of repayment of the servicer's cash advance should be made prior to advancing funds, and the institution should only make such an advance if prudent lending standards are met.

4. Direct Credit Substitute

The proposed definition of direct credit substitute complements the definition of recourse. We propose the term ``direct credit substitute'' to refer to an arrangement in which an institution assumes, in form or in substance, credit risk directly or indirectly associated with an on or offbalance sheet asset or exposure that was not previously owned by the institution (thirdparty asset) and the risk assumed by the institution exceeds the pro rata share of the institution's interest in the thirdparty asset. If the institution has no claim on the thirdparty asset, then the institution's assumption of any credit risk is a direct credit substitute. The term explicitly includes items such as the following:

5. Externally Rated

The proposal defines externally rated to mean that an instrument or obligation has received a credit rating from at least one NRSRO. The use of external credit ratings provides a way to determine credit quality relied upon by investors and other market participants to differentiate the regulatory capital treatment for loss positions representing different gradations of risk. This use permits more equitable treatment of transactions and structures in administering the riskbased capital requirements.

6. Financial Standby Letter of Credit

Section 615.5201(o) of our regulations currently defines the term ``standby letter of credit.'' We propose to change the term to financial standby letter of credit, but propose no substantive changes to the definition.

7. Government Agency

This term is currently defined in two places in our capital regulations: Sec. 615.5201(f), which is our definitions section, and Sec. 615.5210(f)(2)(i)(D), which is our section on computing the permanent capital ratio. We propose to modify the Sec. 615.5201(f) definition by replacing it with the definition of Government agency currently in Sec. 615.5210(f)(2)(i)(D), and then delete the definition in Sec. 615.5210(f)(2)(i)(D). We believe these changes would streamline the regulation. We do not intend to change the meaning of this term.

8. GovernmentSponsored Agency

The term Governmentsponsored agency is also currently defined in two places in our capital regulations (Sec. 615.5201(g), which is in the definitions section, and Sec. 615.5210(f)(2)(ii)(A), which is in the section on computing the permanent capital ratio). We propose to modify the definition in Sec. 615.5201(g) by replacing it with the Sec. 615.5210(f)(2)(ii)(A) definition of Governmentsponsored agency, and then delete the redundant definition in Sec.
615.5210(f)(2)(ii)(A). This proposed change simply streamlines our regulations and does not change the meaning of the term Government sponsored agency.

Under this proposal, the term ``Governmentsponsored agency'' would be defined as an agency or instrumentality chartered or established to serve public purposes specified by the United States Congress but whose obligations are not explicitly guaranteed by the full faith and credit of the United States Government. This definition includes Government sponsored enterprises, such as Fannie Mae and Farmer Mac, as well as Federal agencies, such as the Tennessee Valley Authority, that issue obligations that are not explicitly guaranteed by the United States' full faith and credit.

9. Nationally Recognized Statistical Rating Organization

We propose to define NRSRO as a rating organization that the Securities and Exchange Commission (SEC) recognizes as an NRSRO. This definition
[[Page 47989]]
is identical to the existing definition in Sec. 615.5131(j) of our regulations.

10. NonOECD Bank

We propose to define nonOECD bank as a bank and its branches (foreign and domestic) organized under the laws of a country that does not belong to the OECD group of countries.\28\
\28\ OECD stands for the Organization for Economic Cooperation and Development. The OECD is an international organization of countries that are committed to democratic government and the market economy. For purposes of our capital regulations, as well as those of the other financial regulatory agencies and the Basel Accord, OECD countries are those countries that are full members of the OECD or that have concluded special lending arrangements associated with the International Monetary Fund's General Arrangements to Borrow, excluding any country that has rescheduled its external sovereign debt within the previous 5 years. The OECD currently has 30 member countries. An uptodate listing of member countries is available at http://www.oecd.org or www.oecdwash.org. 11. OECD Bank

We propose to define OECD bank as a bank and its branches (foreign and domestic) organized under the laws of a country that belongs to the OECD group of countries. For purposes of our capital regulations, this term would include U.S. depository institutions.

12. Permanent Capital

We propose to add language to clarify that permanent capital is subject to adjustments such as dollarfordollar reduction of capital for residual interests or other highrisk assets as described in proposed Sec. 615.5207. We do not propose any other changes. 13. Recourse

The proposed rule defines the term ``recourse'' to mean an arrangement in which an institution retains, in form or in substance, any credit risk directly or indirectly associated with an asset it has sold (in accordance with GAAP) that exceeds a pro rata share of the institution's claim on the asset. If an institution has no claim on an asset it has sold, then the retention of any credit risk is recourse. A recourse obligation typically arises when an institution transfers assets in a sale and retains an explicit obligation to repurchase assets or to absorb losses due to a default on the payment of principal or interest or any other deficiency in the performance of the underlying obligor or some other party. Recourse may also exist implicitly if an institution provides credit enhancement beyond any contractual obligation to support assets it has sold.

Our proposed definition of recourse is consistent with the other regulators' longstanding use of this term and incorporates existing practices regarding retention of risk in asset sales. The other financial regulatory agencies noted that thirdparty enhancements, e.g., insurance protection, purchased by the originator of a securitization for the benefit of investors, do not constitute recourse. The purchase of enhancements for a securitization or other structured transaction where the institution is completely removed from any credit risk will not, in most instances, constitute recourse. However, if the purchase or premium price is paid over time and the size of the payment is a function of the third party's loss experience on the portfolio, such an arrangement indicates an assumption of credit risk and would be considered recourse.

14. Residual Interest

The proposed rule defines residual interest as any onbalance sheet asset that: (1) Represents an interest (including a beneficial interest) created by a transfer that qualifies as a sale (in accordance with GAAP) of financial assets, whether through a securitization or otherwise; and (2) exposes an institution to credit risk directly or indirectly associated with the transferred asset that exceeds a pro rata share of that institution's claim on the asset, whether through subordination provisions or other credit enhancement techniques.

Residual interests generally include creditenhancing interestonly strips, spread accounts, cash collateral accounts, retained subordinated interests (and other forms of overcollateralization), and similar assets that function as a credit enhancement. Residual interests generally do not include interests purchased from a third party. However, a purchased creditenhancing interestonly strip is a residual interest because of its similar risk profile.

This functional based definition reflects the fact that financial structures vary in the way they use certain assets as credit enhancements. Therefore, residual interests include any retained on balance sheet asset that functions as a credit enhancement in a securitization or other structured transaction, regardless of its characterization in financial or regulatory reports.

15. Rural Business Investment Companies

The proposed rule adds a definition for RBICs. Section 6029 of the Farm Security and Rural Investment Act of 2002 \29\ amended the Consolidated Farm and Rural Development Act, as amended (7 U.S.C. 1921 et seq.) by adding a new subtitle H, establishing a new ``Rural Business Investment Program.'' The new subtitle permits FCS institutions to establish or invest in RBICs, subject to specified limitations. While the Secretary of Agriculture is responsible for promulgating regulations governing RBICs, the FCA continues to be responsible for addressing any issues pertaining to FCS institutions' investments in RBICs, including riskweighting those investments. We define RBICs by referring to the statutory definition as codified in 7 U.S.C. 2009cc(14). That provision defines RBIC as ``a company that (A) has been granted final approval by the Secretary [of Agriculture] * * * and; (B) has entered into a participation agreement with the Secretary [of Agriculture].''
\29\ Pub. L. 107171.

16. Securitization

The proposed rule defines securitization as the pooling and repackaging by a special purpose entity or trust of assets or other credit exposures that can be sold to investors. Securitization includes transactions that create stratified credit risk positions whose performance is dependent upon an underlying pool of credit exposures, including loans and commitments.

17. Other Terms

We also propose to add definitions for the following terms:

1. Sections 615.5210 and 615.5211General

As described in the overview section of this preamble, each loss position in an asset securitization structure functions as a credit enhancement for the more senior loss positions in the structure. Historically, neither our riskbased capital standards nor those of the other financial regulatory agencies varied the capital requirements for different credit enhancements or loss positions to reflect differences in the relative credit risks represented by the
[[Page 47990]]
positions. To address this issue, the other financial regulatory agencies implemented a multilevel, ratingsbased approach to assess capital requirements on recourse obligations, residual interests (except creditenhancing interestonly strips), direct credit substitutes, and senior and subordinated positions in assetbacked securities and mortgagebacked securities based on their relative exposure to credit risk. The approach uses credit ratings from NRSROs to measure relative exposure to credit risk and determine the associated riskbased capital requirement.

Under this rulemaking, we are proposing to adopt similar requirements. These changes would bring our regulations into close alignment with those of the other financial regulatory agencies for externally rated positions in securitizations with similar risks. We are also proposing to apply a ratingsbased approach to unrated positions in Governmentsponsored agency securitizations based on the issuer's credit rating beginning 18 months after the effective date of a final rule.

Currently, the other financial regulatory agencies do not apply a ratingsbased approach to securities issued by Governmentsponsored agencies; these securities are generally riskweighted at 20 percent. The other financial regulatory agencies do, however, apply the ratings based approach to rated positions in privately issued mortgage securities (e.g. collateralized mortgage obligations and real estate investment conduits) that are backed by agency mortgage passthrough securities. Further, the other financial regulatory agencies uniformly riskweight stripped mortgage backed securities issued by Government sponsored agencies at 100 percent because of their higher risk assessment. Additionally, the other financial regulatory agencies reserve the authority to require a higher risk weighting on any position (including positions in Governmentsponsored agency securitizations) based on the underlying risks of the position.

The market has historically regarded securities issued by Governmentsponsored agencies as posing minimal credit risk. However, we are concerned that subordinated positions, residual interests, or exposures to counterparties (including Governmentsponsored agencies) that are not highly rated or are unrated may pose significant risks to FCS institutions. We are also concerned about the unique structural and operational risks that securitizations may present. Therefore, we believe it is appropriate to apply the ratingsbased approach to all positions in securitizations that are not guaranteed by the full faith and credit of the United States.

Furthermore, the use of credit ratings would provide an objective basis for determining credit quality as relied upon by investors or other market participants. These ratings would then be used to differentiate the regulatory capital treatment for loss positions based on different gradations of risk. This approach would enable us to apply the riskbased capital treatment to a wide variety of transactions and structures in a more equitable manner.

Additionally, Sec. 615.5210(f) of the proposed regulation would grant FCA the authority to override the use of certain ratings or the ratings on certain instruments, either on a casebycase basis or through broader supervisory policy, if necessary or appropriate to address the risk that an instrument poses to FCS institutions. 2. Section 615.5210(b)Positions that Qualify for the RatingsBased Approach

Under Sec. 615.5210(b) of our proposed rule, certain positions in securitizations qualify for the ratingsbased approach. These positions in securitizations are eligible for the ratingsbased approach, provided the positions have favorable external ratings (as explained below) by at least one NRSRO. Eighteen months after the effective date of the final rule, the ratings based approach will be implemented for unrated positions in securitizations that are guaranteed by Government sponsored agencies based on the issuer credit rating of the agency. During the transition period before this provision is effective, FCS institutions may continue to riskweight their unrated positions in securitizations that are guaranteed by Governmentsponsored agencies at 20percent, regardless of whether the agency maintains an issuer rating by an NRSRO.

More specifically, the following positions in securitizations qualify for the ratingsbased approach if they satisfy the criteria set forth below:

Under proposed Sec. 615.5210, the capital requirement for a position that qualifies for the ratingsbased approach is computed by multiplying the face amount of the position by the appropriate risk weight as determined by the position's external credit rating. In the case of unrated positions in securitizations guaranteed by Government sponsored agencies beginning 18 months after the effective date of the final rule, the issuer's credit rating will be used to determine the appropriate riskweight for the position.

A position that is traded and externally rated qualifies for the ratingsbased approach if its longterm external rating is one grade below investment grade or better (e.g., BB or better) or its shortterm external rating is investment grade or better (e.g., A3, P3).\31\ If the position receives more than one external rating, the lowest rating would apply. This requirement eliminates the potential for rating shopping. Currently, individual securities issued and guaranteed by Governmentsponsored agencies generally do not have external ratings from NRSROs. If, however, a position in an agency securitization does have an external rating, that rating must be used to determine the appropriate riskweighting for the position.
\31\ These ratings are examples only. Different NRSROs may have different ratings for the same grade.

A position that is externally rated but not traded qualifies for the ratingsbased approach if it satisfies the following criteria:

The proposed rule also specifically provides that an unrated position that is guaranteed by a Governmentsponsored agency would qualify for the ratingsbased approach based on the Government sponsored agency's issuer credit rating beginning 18 months after the effective date of the final rule.

Under the ratingsbased approach, the capital requirement for a position that qualifies for the ratingsbased approach
[[Page 47991]]
is computed by multiplying the face amount of the position by the appropriate risk weight determined in accordance with the following tables: \32\
\32\ See paragraphs (b)(14), (c)(3), (d)(6), and (e) of proposed Sec. 615.5211.
RiskBased Capital Requirements for LongTerm Issue or Issuer Ratings Rating category Rating examples \33\ Risk weight (in percent) Highest or second highest investment AAA or AA.............. 20. grade.
Third highest investment grade...... A...................... 50. Lowest investment grade............. BBB.................... 100. One category below investment grade. BB..................... 200. More than one category below B or below or Unrated.. Not eligible for the ratingsbased approach. investment grade, or unrated.
RiskBased Capital Requirements for ShortTerm Issue Ratings Shortterm rating category Rating examples Risk weight (in percent) Highest investment grade............ A1, P1............... 20. Second highest investment grade..... A2, P2............... 50. Lowest investment grade............. A3, P3............... 100. Below investment grade, or unrated.. B or lower (Not Prime). Not eligible for the ratingsbased approach.

The charts for longterm and shortterm ratings are not identical because rating agencies use different methodologies. Each shortterm rating category covers a range of longerterm rating categories. For example, a P1 rating could map to a longterm rating as high as Aaa or as low as A3.
\33\ These ratings are examples only. Different NRSROs may have different ratings for the same grade. Further, ratings are often modified by either a plus or minus sign to show relative standing within a major rating category. Under the proposed rule, ratings refer to the major rating category without regard to modifiers. For example, an investment with a longterm rating of ``A'' would be risk weighted at 50 percent.

These proposed amendments would not change the riskweight requirement that FCA recently adopted for eligible asset and mortgage backed securities that continue to be highly rated.\34\ These amendments simply make our rule language more consistent with that used by the other financial regulatory agencies for these types of transactions.
\34\ See 68 FR 15045, March 24, 2003.
C. Section 615.5210(c)Treatment of Positions in Securitizations That Do Not Qualify for the RatingsBased Approach
1. Section 615.5210(c)(1), (c)(2), and (c)(3)Positions Subject to DollarforDollar Capital Treatment

We propose to subject certain positions in asset securitizations that do not qualify for the ratingsbased approach to dollarfordollar capital treatment. These positions include:

We emphasize that creditenhancing positions in securitizations of Governmentsponsored agencies are subject to the same capital treatment as positions in nonagency securitizations with similar risk profiles. For example, if an FCS institution retains or purchases an unrated subordinated interest in a Governmentsponsored agency securitization that provides a credit enhancement for the entire pool of loans in the securitization, then the FCS institution must hold capital dollarfor dollar for the amount of that position.

Under the dollarfordollar treatment, an FCS institution must deduct from capital and assets the face amount of the position. This means, in effect, one dollar in total capital must be held against every dollar held in these positions, even if this capital requirement exceeds the full riskbased capital charge.

We propose the dollarfordollar treatment for the creditenhancing and highly subordinated positions listed above because these positions raise a number of supervisory concerns that the other financial regulatory agencies also share.\36\ The level of credit risk exposure associated with deeply subordinated assets, particularly subinvestment grade and unrated residual interests, is extremely high. They are generally subordinated to all other positions, and these assets are subject to valuation concerns that might lead to loss as explained further below. Additionally, the lack of an active market makes these assets difficult to independently value and relatively illiquid. \36\ See 66 FR 59614 (November 29, 2001).

In particular, there are a number of concerns regarding residual interests. A banking organization can inappropriately generate ``paper profits'' (or mask actual losses) through incorrect cash flow modeling, flawed loss assumptions, inaccurate prepayment estimates, and inappropriate discount rates. Such practices often lead to an inflation of capital, falsely making the banking organization appear more financially sound. Also, embedded within residual interests, including creditenhancing interestonly strips, is a significant level of credit and prepayment risk that make their valuation extremely sensitive to changes in underlying assumptions. For these reasons we, like the other financial regulatory agencies, concluded that a higher capital requirement is warranted for unrated residual interests and all credit enhancing interestonly strips. Furthermore, the ``lowlevel exposure rule,'' discussed below, does not apply to these positions in securitizations. For example, if an FCS institution holds a 10percent residual interest that is not externally rated in a $100 million [[Page 47992]]
securitization, its capital charge would be $10 million. If an FCS institution purchases a $25 million position in an ABS that is subsequently downgraded to B or lower, its capital charge would be $25 million, the full amount of the position.

We note that the final rules adopted by the other financial regulatory agencies impose both a dollarfordollar risk weighting for residual interests that do not qualify for the ratingsbased approach and a concentration limit on a subset of those residual interests creditenhancing interestonly stripsfor the purpose of calculating a bank's leverage ratio. Under their combined approach, creditenhancing interestonly strips are limited to 25 percent of a banking organization's Tier 1 capital. Everything above that amount is deducted from Tier 1 capital. Generally, under the other financial regulatory agencies' rules, all other residual interests that do not qualify for the ratingsbased approach (including any creditenhancing interest only strips that were not deducted from Tier 1 capital) are subject to a dollarfordollar risk weighting. The combined capital charge is limited to the face amount of a banking organization's residual interests.

As indicated previously, we are proposing a onestep approach for these positions in securitizations. This would require FCS institutions to deduct from capital and assets the face amount of their position. The resulting total capital charge is virtually the same under both approaches. However, we found that the onestep approach is easier to apply to FCS institutions because the way they compute their regulatory capital standards differs from the way other banking organizations compute their standards.
2. Section 615.5210(c)(4)Unrated Recourse Obligations and Direct Credit Substitutes

As discussed in the definitions section, the contractual retention of credit risk by an FCS institution associated with assets it has sold generally constitutes recourse.\37\ The definitions of recourse and direct credit substitute complement each other, and there are many types of recourse arrangements and direct credit substitutes that can be assumed through either on or offbalance sheet credit exposures that are not externally rated. Under Sec. 615.5210(c)(4) of this proposal, FCS institutions would be required to hold capital against the entire outstanding amount of assets supported (e.g., all more senior positions) by an onbalance recourse obligation or direct credit substitute that is unrated. This treatment parallels our approach for offbalance sheet recourse obligations and direct credit substitutes, as discussed later under the computation of credit equivalent amounts. For example, if an FCS institution retains an onbalance sheet first loss position through a recourse arrangement or direct credit substitute in a pool of rural housing loans that qualify for a 50 percent risk weight, the FCS institution would include the full amount of the assets in the pool, riskweighted at 50 percent, in its risk weighted assets for purposes of determining its riskbased capital ratios. The lowlevel exposure rule \38\ provides that the dollar amount of riskbased capital required for assets transferred with recourse should not exceed the maximum dollar amount for which an FCS institution is contractually liable.
\37\ As previously discussed, the proposed rule defines the term ``recourse'' to mean an arrangement in which an institution retains, in form or in substance, any credit risk directly or indirectly associated with an asset it has sold, if the credit risk exceeds a pro rata share of the institution's claim on the asset. If an institution has no claim on an asset that it has sold, then the retention of any credit risk is recourse.

\38\ See proposed Sec. 615.5210(e).

The other financial regulatory agencies currently permit their banking organizations to use three alternative approaches (i.e., internal ratings, program ratings, and computer programs) for determining the capital requirements for certain unrated direct credit substitutes and recourse obligations in assetbacked commercial paper programs. The other financial regulatory agencies also recently issued an interim final rule and a proposed rule on the capital treatment for assetbacked commercial paper programs that are consolidated onto the balance sheets of the sponsoring banks. This change is the result of a recently issued accounting interpretation, Financial Accounting Standards Board Interpretation No. 46, Consolidation of Variable Interest Entities.\39\ At this time, the FCA has decided not to address the capital requirements for assetbacked commercial paper programs due to the limited involvement FCS institutions presently have in these programs. FCA will continue to determine the capital requirements for such programs on a casebycase basis, but does request further comment on the appropriate capital treatment for these activities.
\39\ See 68 FR 56530 (October 1, 2003).
3. Sections 615.5210(c)(5) and 615.5211(d)(7)Stripped MortgageBacked Securities (SMBS)

Under proposed Sec. Sec. 615.5210(c)(5) and 615.5211(d)(7), SMBS and similar instruments, such as interestonly strips that are not creditenhancing or principalonly strips (including such instruments guaranteed by Governmentsponsored agencies), are assigned to the 100 percent riskweight category. Even if highly rated, these securities do not receive the more favorable capital treatment available to other mortgage securities because of their higher market risk profile. Typically, SMBS contain a higher degree of price volatility associated with mortgage prepayments. As indicated previously, creditenhancing positions in securitization are subject to dollarfordollar capital treatment.
4. Section 615.5211(d)Unrated Positions in AssetBacked Securities and MortgageBacked Securities

Unrated positions in mortgage and assetbacked securities that do not qualify for the ratingsbased approach would generally be assigned to the 100percent riskweight category under the proposal. This would include unrated positions in securitizations guaranteed by Government sponsored agencies without issuer credit ratings beginning 18 months after the effective date of the final rule.

The FCA recognizes that the proposed riskbased capital requirements can provide a more favorable treatment for certain unrated positions in securitizations than those rated below investment grade. For this reason, FCA will look to the substance of the transaction to determine whether a higher capital requirement is warranted based on the risk characteristics of the position. Additionally, because of the many advantages, including pricing, liquidity, and favorable capital treatment on highly rated positions in asset securitizations, we believe this overall regulatory approach provides ample incentives for all participants to obtain external ratings.
D. Section 615.5210(d)Senior Positions Not Externally Rated

For senior positions not externally rated, the following capital treatment applies under proposed Sec. 615.5210(d). If an FCS institution retains an unrated position that is senior or preferred in all respects (including collateral and maturity) to a rated position that is traded, the position is treated as if it had the same rating assigned to the rated position. These senior unrated positions [[Page 47993]]
qualify for the risk weighting of the subordinated rated positions as long as the subordinate rated position is: (1) Traded; and (2) remains outstanding for the entire life of the unrated position, thus providing full credit support for the term of the unrated position.

E. Section 615.5210(e)LowLevel Exposure Rule

Section 615.5210(e) of the proposed rule limits the maximum risk based capital requirement to the lesser of the maximum contractual exposure or the full capital charge against the outstanding amount of assets transferred with recourse. When the proposed lowlevel exposure rule applies, an institution would generally hold capital dollarfor dollar against the amount of its maximum contractual exposure. Thus, if the maximum contractual exposure to loss retained or assumed in connection with recourse obligation or a direct credit substitute is less than the full riskbased capital requirement for the assets enhanced, the riskbased capital requirement is limited to the maximum contractual exposure.

In the absence of any other recourse provisions, the onbalance sheet amount of assets retained or assumed in connection with a recourse obligation or direct credit substitute represents the maximum contractual exposure. For example, assume that $100 million of loans is sold and securitized and an FCS institution provides a $5 million credit enhancement through a recourse obligation. Instead of holding 7 percent or $7 million of capital, the lowlevel exposure limits the riskbased requirement to the $5 million maximum contractual loss exposure, with $5 million held dollarfordollar against capital. F. Section 615.5211Risk CategoriesBalance Sheet Assets
1. Section 615.5211(b)(6)Securities and Other Claims on, and Portions of Claims, Guaranteed by GovernmentSponsored Agencies

Under proposed Sec. 615.5211(b)(6), securities and other claims on, and portions of claims guaranteed by, Governmentsponsored agencies are generally assigned to the 20percent riskweight category.\40\ For example, this riskbased capital treatment applies to investments in debt securities or other similar obligations issued by agencies. Beginning eighteen months after the ef

FOR FURTHER INFORMATION CONTACT

Laurie A. Rea, Senior Policy Analyst, Office of Policy and Analysis, Farm Credit Administration, McLean, VA 221025090, (703) 8834479; TTY (703) 8834434;
or
Jennifer A. Cohn, Senior Attorney, Office of General Counsel, Farm Credit Administration, McLean, VA 221025090, (703) 8834020, TTY (703) 8832020.