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US Set for Pivotal Capital-Reserve Ruling
Asset Backed Alert, Harrison Scott Publications Inc. (August 14, 2009)

U.S. government officials are aiming for September to decide once and for all how banks' capital reserves should reflect a tidal wave of securitized assets that are headed for their balance sheets.

The landmark ruling, from the FDIC, Federal Reserve, Office of the Comptroller of the Currency and Office of Thrift Supervision, would mark one of the final steps in determining the impact of the Financial Accounting Standards Board's FAS 167. At issue are the costs issuers incur in tending to huge volumes of already-securitized assets, and when, or if, securitization might re-emerge as a popular funding source.

The timing of the government's planned decision fits in with ongoing attempts to prepare for the implementation of the FAS 167 guidelines. Those long-developing rules, finalized this year, followed a previous decision to eliminate an accounting designation for bond-issuing vehicles known as qualified special purpose entities - which issuers have long employed to remove securitized assets from their balance sheets.

Instead, the "primary beneficiary" of each securitization, typically the issuer, would have to list the collateral on their books beginning in January. But it's up to the government to decide how banking institutions would have to set aside capital against those assets. Under current rules, banks would be exposed to full withholding requirements immediately upon "consolidating" their assets - instantly killing one of the most advantageous aspects of asset-backed bond sales while forcing them to raise heaps of fresh capital in a down market. The belief is that the greatest impact would be felt among institutions such as Bank of America, Citigroup and J.P. Morgan that have issued credit-card bonds, due to heavy deal volume in that sector.

Capital-reserve calculations vary with the risk associated with the assets involved, but the types of assets those banks might bring onto their balance sheets would typically be subject to a straight 8% requirement. That means a $100 million asset pool would necessitate $8 million of added capital.

The fact that the government is even weighing in on the matter is giving market players hope of some sort of reprieve. Indeed, the efforts appear geared toward lessening the immediate impact of FAS 167 from a capital-adequacy standpoint, as many banks have already struggled to keep their capital reserves at appropriate levels amid the global financial crisis. The government has also sought to ensure that financial institutions can continue to fund themselves through securitization.

However, nobody is suggesting that banks be completely spared from setting aside additional capital as a result of FAS 167. A more likely scenario would be a gradual phase-in of full capital-adequacy requirements, giving the institutions more time to raise the necessary money. That said, the government's plans are murky. Members of the American Securitization Forum met with Fed officials last week to discuss the matter, but walked away without much insight on the central bank's stance.

In testimony to the U.S. Senate Finance Committee last week, FDIC Chairman Sheila Bair said banks would ultimately have to hold capital against the newly on-balance-sheet receivables. She also expressed fears about what such a shift would do to the still-vulnerable market. "If more assets are coming on-balance-sheet, capital levels are going to be impacted accordingly," she said in response to a question from Sen. David Vitter (R-La.). "We support the general direction of bringing all this back on-balance-sheet." she added, noting that the timeline for implementing FAS 167 "still gives me some heartburn."

Bair said the FDIC lacks the authority to push back the FASB guidelines, but Comptroller of the Currency John Dugan asserted at the same hearing that, "There is some flexibility to look at this and phase it in over some time."

Some industry participants are expecting the agencies to decide on a phase-in period of 3-5 years for the added set-asides, largely to avoid spooking existing and prospective holders of banks' debt and equity. Still, Mayer Brown partner Jason Kravitt estimates that more than $1 trillion of already-securitized assets could eventually come back onto bank balance sheets, and that the institutions would have to raise capital against all of those holdings. "The drama of this is, imagine how many securitizations banks have done and remain outstanding," said Kravitt, who helped found the ASF.

Looking forward, the likely result is that securitization would be used by banks purely for funding purposes, as opposed to being viewed as a balance-sheet management tool. The effect would be a slowdown in deal production, as issuers turn to other on-balance sheet mechanisms as costs dictate. Non-bank institutions wouldn't be affected.

In the meantime, credit-card lenders might have to add to their reserves even sooner. That's because many of them added credit enhancement to outstanding deals in response to deteriorating collateral performance, which could force them to bring the underlying receivables onto their balance sheets regardless of FAS 167 rules.

As for other areas exposed to the new accounting guidelines, it doesn't look like treatment of commercial-paper conduits will change - meaning banks will have to continue holding capital against liquidity lines they write, but not the underlying portfolios. FASB's elimination of the QSPE designation dovetails with U.S. government implementation this year of its own version of Bank for International Settlements' New Basel Capital Accord, a set of risk-based capital-adequacy requirements also known as Basel 2. The U.S. blueprint typically sets more stringent requirements than the BIS rules.



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