United States: Federal Banking Agencies Proposed Basel II Securitization and Equity Exposure Rules
(Financial Services Alert – Developments of Note)

1. Federal Banking Agencies Proposed Basel II Securitization and Equity Exposure Rules
2. Federal Banking Agencies Issue Final Guidance Concerning Nontraditional Mortgage Product Risks
3. SEC Extends Rule 22c-2 Compliance Date for Shareholder Information Agreements, Adds New Information Exchange Compliance Date and Amends Rule
4. OCC Chief Counsel Testifies on Scope of Impact of December 2005 Interpretive Letters Concerning Bank Premises and Investment in Wind Energy Project

5. Materials from SEC Regional CCOutreach Seminars Available on SEC Website
6. Webinar Concerning Reducing the Risk of Stock Options Backdating

Federal Banking Agencies Proposed Basel II Securitization and Equity Exposure Rules

The federal banking agencies’ (the "Agencies") joint notice of proposed rulemaking (the "NPR") regarding Basel II discussed in the September 12, 2006, September 19, 2006 and September 26, 2006 Alerts, also provides a framework for addressing capital issues in the context of securitization transactions and equity exposures. These issues are discussed in this Article.

A bank that satisfies certain operational requirements and observes restrictions on the provision of implicit recourse to securitizations originated by it must use the securitization framework set forth in Part V of the NPR for on-balance sheet or off-balance sheet credit exposure that arises from the tranching of credit risk of financial assets representing wholesale, retail or equity exposures. Provided that there is a tranching of credit risk, securitization exposures could include financial asset exposures such as asset-backed and mortgage-backed securities, loans, lines of credit, liquidity facilities, and financial standby letters of credit, credit derivatives and guarantees, loan servicing assets, servicer cash advance facilities, reserve accounts, credit enhancing representations and warranties and credit enhancing interest only strips. Both traditional securitizations and synthetic securitizations are covered by the NPR.

Risk-Weighting Approaches. The proposed securitization framework contains three general approaches for determining the risk based capital requirement for a securitization exposure: a Ratings- Based Approach (the "RBA"), an Internal Assessment Approach (the "IAA") and a Supervisory Formula Approach (the "SFA"). All of these approaches are applicable to traditional securitizations, and the RBA and SFA also are applicable to synthetic securitizations.

RBA. Under the RBA, the risk-based capital requirement per dollar of securitization exposure would depend on the applicable external rating or inferred rating of the exposure and whether that rating reflects a long-term or short-term assessment of the exposure’s credit risk, the seniority of the exposure and the granularity of the underlying exposures. The risk weight for a low investment grade securitization exposure (i.e. BBB-) is 100%. For more highly rated securitization positions the risk weights range from 7% to 75% based on the rating (graduation within a rating category) and seniority of the securitization exposure and the granularity of the pool. For high non-investment grade securitization exposures (i.e. BB+ to BB-) risk weights range from 250% to 650% regardless of seniority of the exposure and granularity of the pool.

SFA. Under the SFA, the risk-based capital requirement per dollar of securitization exposure is derived by applying seven factors to a single complicated formula that reflects a blend of credit risk modeling results and supervisory judgments. The seven factors cover the size and seniority of the tranche, the securitization exposure’s proportion of the tranche in which it resides, the granularity and loss given default of the underlying exposures and the risk-based capital requirements and expected credit losses for the underlying exposures if the bank held them directly on its balance sheet without securitizing them. A bank may only use the SFA to determine its risk-based capital requirement for a securitization exposure if the bank can calculate each of the seven inputs on an ongoing basis. The SFA formula effectively imposes a 7% risk-weight floor on any securitization exposure for which the SFA approach is used, thus reducing incentives for regulatory capital arbitrage between the RBA and the SFA.

IAA. The IAA is the only approach under the securitization framework that under which a bank may use its own internal assessment of credit quality. It is only applicable to securitization exposures to an asset-backed commercial paper ("ABCP") program, such as a liquidity facility or credit enhancement. In order to use the IAA, a bank must receive prior written approval from its primary federal banking supervisor. In order to receive such approval the bank must demonstrate that its internal assessment process and the ABCP program meet certain qualification requirements, and the securitization exposure must initially be internally rated at least equivalent to investment grade.

Hierarchy of Risk-Weighting Approaches. Generally speaking, a specific securitization exposure must be risk weighted (or deducted from capital) in accordance with one of these approaches in accordance with the following hierarchy:

• First, a bank must deduct from tier 1 capital any after-tax gain-on-sale resulting from a securitization and must deduct from total capital any portion of a credit enhancing interest only strip that does not constitute a gain on-sale.

• Second, a bank must apply the RBA to any other securitization exposure that has the requisite number of external or inferred ratings to qualify for the RBA. For an originating bank the requisite number is two; for an investing bank the requisite number is one.

• If a securitization exposure is not a gain-on-sale or a credit-enhancing interest-only strip, does not qualify for the RBA and is not an exposure to an ABCP program, the bank may apply the SFA to the exposure if the bank is able to calculate the SFA risk factors for the securitization and if the underlying exposures are wholesale, retail or equity exposures.

• If a securitization exposure does not qualify for the RBA but is an exposure to an ABCP program—such as a credit enhancement or liquidity facility—the bank may apply the IAA (if the bank, the exposure, and the ABCP program qualify for the IAA) or the SFA (if the bank and the exposure qualify for the SFA) to the exposure.

• Lastly, if a securitization exposure does not qualify for treatment as described above, the bank must deduct the exposure from total capital

Notwithstanding the foregoing, the total risk-based capital requirement for all securitization exposures held by a single bank associated with a single securitization may not exceed the sum of (i) the bank’s total risk-based capital requirement for the underlying exposures as if the bank directly held the underlying exposures and (ii) the bank’s total expected credit loss for the underlying exposures. The proposed rule contains several other exceptions to the general hierarchy described above to address certain particular issues, including the regulatory capital treatment of overlapping exposures to ABCP programs, risk weighting of assets of ABCP programs that are consolidated on the bank’s balance sheet under GAAP, undrawn portions of servicer advance facilities related to a securitization and early amortization features in revolving securitization structures. Generally speaking, the regulatory capital treatment of these issues under the NPR is consistent with the treatment of them under existing regulations and supervisory guidance.

Synthetic Securitizations. Owing to the complexities of synthetic securitizations, the NPR contains extensive guidance for buyers and sellers of credit protection with respect to the application of the hierarchy of securitization approaches to tranched risk transfers using credit derivative instruments in a variety of circumstances, including first-loss tranches, mezzanine tranches, first-to-default swaps and nth-to-default swaps and synthetic securitizations in which credit protection is provided by a special purpose entity that collateralizes its obligations. In order for a bank to receive credit for risk transfer through a credit derivative the credit derivative must satisfy the requirements for guarantees and credit derivatives that cover wholesale exposure, including minimum credit events, a 40% reduction in the recognized credit protection provisions intended to establish correlation between the reference exposure and the valuation or deliverable exposure, robust valuation provisions in cash-settlement and provisions to facilitate the transfer of deliverable exposure. In addition, an originating bank that acquires credit protection through a credit default swap that does not include as a credit event a restructuring that involves forgiveness or postponement of principal, interest, or fees that results in a charge-off, specific provision, or other similar debit to the profit and loss account would have to reduce the recognition of the credit derivative by 40%. The provisions of the NPR that relates to synthetic securitizations are generally consistent with the Agencies’ existing supervisory guidance with respect to synthetic securitizations.

With respect to equity exposures under the credit risk rules (as opposed to the market risk rules in the September 26, 2006 Alert) a banking institution has the option to use either a simple risk-weight approach ("SRWA") or an internal models approach ("IMA") to calculate exposures not part of an investment fund.

Calculating the Carrying Value. For purposes of making any of the equity exposure calculations (either for the SWRA or the IMA, or even for the special rules regarding investment funds), a bank must calculate its "adjusted carrying value" for each exposure. For on-balance sheet exposures, adjusted carrying value generally is the bank’s carrying value for the exposure reduced by unrealized gains excluded from a bank’s capital. For off-balance sheet exposures, the adjusted carrying value generally is the effective notional principal amount of the exposure determined by reference to an equivalent on balance sheet exposure.

Effect of Hedging. The NPR provides a mechanism for banks to identify hedge pairs (i.e., two equity exposures that form an "effective hedge" and are either publicly-traded or have a return based primarily on a publicly-traded exposure), and provides a special calculation of the risk capital resulting from them. To have an effective hedge, among other things, the exposures generally must have equivalent remaining maturities, documentation specifying the effectiveness of the hedge, and in fact be effective.

SWRA. Under the SRWA, a bank generally (subject to an exception for sovereigns and similar high quality exposures ) assigns a 300% risk weight to publicly-traded exposures (generally a security traded on a US or foreign national exchange), and a 400% risk weight to non-publicly traded exposures. The SWRA provides a concept of "non-significant equity exposures", which have a 100% risk weight and the NPR define as having an aggregate adjusted carrying value (excluding, e.g., exposures with less than a 300% risk weight and certain hedged pairs) that does not exceed 10% of the bank’s tier 1 capital plus tier 2 capital.

IMA. Banks must first obtain regulatory approval to use the IMA. While the NPR does not require banks to have a Value at Risk ("VaR") approach to use the IMA, the bank’s model must have the accuracy of a VaR methodology and be able to assess the potential decline in equity exposures, be appropriate for the complexity of the bank’s holdings, and adequately capture both general market risk and idiosyncratic risks. A bank may apply the IMA only to its publicly traded equity exposures or to its publicly traded and non-publicly traded exposures, but in either event must exclude certain highly rated equity exposures (e.g., those that would receive a 0-20% risk weight outside the IMA). The NPR also proposes a supervisory floor on the risk weights resulting from the IMA, generally 200% in the case of publicly-traded equity exposures, and 300% in the case of non-publicly traded exposures.

Investment Funds. The NPR also devotes a subsection to the treatment of equity exposures with respect to investment funds (i.e., funds with no material liabilities that consist principally of financial assets) in which a banking institution holds an interest. Basically, the NPR allows three different approaches to these exposures (banks can choose different approaches for different funds): the Full Look-Through Approach, the Simplified Modified Look-Through Approach, and the Alternative Modified Look-Through Approach. As might be expected, under the Full Look-Through Approach, a bank must be able to compute a risk-weighted asset amount for each exposure held by the investment fund as if it were held by the bank directly. The NPR then provides a calculation setting a floor equal to 7% of the adjusted carrying value of the bank’s equity exposure in the fund. The Simplified Modified Look-Through Approach permits a bank to set a risk-weighted asset amount for a fund equal to the adjusted carrying value of the exposure multiplied by the highest risk weight in a NPR-provided table for any exposure that the fund is permitted to hold under its governing documents (subject again to a 7% floor). Finally, under the Alternative Modified Look-Through Approach, a bank may assign the adjusted carrying value of an investment fund on a pro-rata basis to different risk-weight categories according to the investment limits for different asset classes in the fund’s governing documents (again with a 7% floor, and with conservative adjustments if the fund governing documents would permit aggregate limits on all investment categories in the fund to exceed 100%).

The FRB, FDIC, OCC, OTS, and NCUA (the "Agencies") jointly issued final guidance (the "Guidance") on nontraditional mortgage products, setting forth risk management parameters and consumer protection guidance in response to concerns that such products are untested in a stressed market. The Guidance as finalized applies to all negative amortization and interest-only mortgage products, but does not apply to reverse mortgages, fully amortizing residential mortgage loan products, or home equity lines of credit ("HELOCs") (except to the extent a HELOC is offered as a second-lien product.) The Agencies did not include HELOCs because they are already covered by their May 2005 Credit Risk Management Guidance for Home Equity Lending.

Loan Terms and Underwriting Standards. The Guidance states that lenders’ qualification standards should include a credible analysis of each borrower’s repayment capacity. This analysis should account for potential "payment shock" by analyzing the borrower’s ability to repay the loan at the fully-indexed rate, assuming a fully amortizing payment (including any potential negative amortization), that would apply after the introductory period and that takes rate increases into account (on an ARM). In addition, the Guidance cautions lenders against originating collateral-dependent loans and provides parameters for offering "risk-layered" products and reduced-documentation loans. The Guidance states that loans to individuals who do not demonstrate the capacity to repay, as structured, from sources other than the collateral pledged are generally considered unsafe and unsound.

Risk Management Practices. The Guidance states that lenders should implement strong risk management standards, capital levels commensurate with the risk, and an allowance for loan and lease losses that reflect collectibility. As finalized, the Guidance clarifies that the intent is not to set concentration limits for nontraditional mortgage products, but rather is to ensure that such products are supported by well-developed risk management practices. To that end, lenders should design and implement control systems that establish procedures for reporting to management, monitoring and early detection of problems, and due diligence and monitoring of third parties. Specific control systems are not prescribed, nor are lenders required to assume an unwarranted level of responsibility; rather, the Guidance explains that such control systems are expected to be consistent with the Agencies’ current supervisory policies.

Consumer Protection. The Guidance provides a set of recommended practices to make certain that borrowers have sufficient information to clearly understand loan terms and associated risks. In particular, lenders should present clear and balanced information as to the benefits and the risks of nontraditional mortgage products, when borrowers are shopping for products (i.e., before application when disclosures are traditionally provided).

Simultaneous with the Guidance, the Agencies released proposed illustrations of the consumer disclosures described in the Guidance. Comments on the proposed illustrations are due 60 days after publication in the Federal Register.

Finally, the Agencies also issued an amendment to their May 2005 Interagency Credit Risk Management Guidance for Home Equity Lending that provides additional guidance (similar to the Guidance described above) for managing risks associated with HELOCs that contain interest-only features.

The SEC issued a release (the "adopting release") (a) postponing until April 16, 2007 the date by which funds must enter into the shareholder information agreements called for by Rule 22c-2 under the Investment Company Act of 1940, as amended, (b) establishing a new compliance date of October 16, 2007 by which time funds must be able to request and promptly receive information under Rule 22c-2 shareholder information agreements, (c) adopting amendments to the shareholder information agreement portion of Rule 22c-2 and (d) reaffirming its decision not to take any action to standardize the terms of redemption fees. Some highlights of the adopting release are discussed below.

Extension of Compliance Date for Shareholder Information Agreements. The adopting release extends until April 16, 2007, the date by which funds must enter into shareholder information agreements with their intermediaries pursuant to the Rule, and extends by 12 months, until October 16, 2007, the date by which funds must be able to request and promptly receive shareholder identity and transaction information pursuant to shareholder information agreements. This latter extension is designed to allow additional time for funds, intermediaries and others to revise their systems to accommodate the request, provision and use of information from intermediaries after the negotiation of shareholder information agreements.

Amendments to Rule 22c-2. The amendments, which affect only the portion of the Rule dealing with shareholder information agreements, are substantially those in the SEC’s original proposal (which was discussed in the March 27, 2006 Alert), with some changes in response to public comment. In general terms, the shareholder information agreement portion of the Rule requires each of a fund’s financial intermediaries to enter into a written agreement that requires the intermediary (i) to provide certain information regarding underlying shareholders and their trading activities at the fund’s request and (ii) agree to follow instructions from the fund to restrict trading by underlying shareholders under certain circumstances. The amendments revise the Rule in the four following basic ways:

• They carve back the definition of "financial intermediary" to exclude "any person that the fund treats as an individual investor with respect to the fund’s policies established for the purpose of eliminating or reducing any dilution of the value of the outstanding securities issued by the fund."

• They expand the parties eligible to enter into a shareholder information agreement on a fund’s behalf (formerly only the fund’s distributor) to include a fund’s transfer agent.

• They address the issue of multiple layers of intermediaries. The amendments require shareholder information agreements only with those intermediaries that submit purchase and redemption orders, themselves or through an agent, directly to a fund, its principal underwriter or transfer agent, or a registered clearing agency ("first-tier intermediaries"). Those shareholder information agreements must, however, obligate the first-tier intermediary to use its best efforts to determine, upon request by the fund, whether any person that holds shares through the first-tier intermediary is also an intermediary (an "indirect intermediary"), and upon further request from the fund, either (a) provide (or arrange to have provided) underlying shareholder identity and transaction information for shareholders maintaining accounts with the indirect intermediary or (b) restrict or prohibit the indirect intermediary’s further purchase activity.

• The amendments clarify the Rule’s effect when a fund intermediary has not entered into a shareholder information agreement by providing that under those circumstances a fund must prohibit the intermediary from purchasing fund shares in nominee name on behalf of other persons.

Some of the changes made by the SEC to its original proposal are as follows:

• Registered clearing agencies are not among the entities that may enter into a shareholder information agreement on a fund’s behalf (which means that only principal underwriters and transfer agents may act in that capacity).

• Under the amendments as adopted, an intermediary responding to an information request with respect to a non-U.S. shareholder may provide an International Taxpayer Identification Number or other government issued identifier if no Taxpayer Identification Number is available.

• A shareholder information agreement need not obligate a first-tier intermediary to perform at the fund’s request a complete review of the intermediary’s books and records to identify all indirect intermediaries. Instead, a shareholder information agreement must only require that a first-tier intermediary use its best efforts to identify whether or not particular accounts specified by a fund (after receiving identification and transaction information provided pursuant to the agreement) are indirect intermediaries.

• If there is no shareholder information agreement with a particular intermediary, the prohibition against purchases of fund shares by that intermediary applies only to purchases "in nominee name on behalf of other persons." The adopting release notes that the prohibition therefore does not apply to purchases by the intermediary for its own account (as it did under the SEC’s original proposal) or purchases that are fully disclosed to the fund. In addition, the amended Rule now indicates that under these circumstances automatic dividend reinvestments do not constitute purchases of fund securities.

Information Requests - Frequency. The adopting release discusses the SEC’s decision not to impose limits on the frequency of requests for information under the terms of a shareholder information agreement, and lists the following factors that a fund could consider in determining how often to make those requests:

1. unusual trading patterns, such as abnormally large inflows or outflows, that may indicate the existence of frequent trading abuses;
2. the risks that frequent trading poses to the fund and its shareholders in light of the nature of the fund and its portfolio;
3. the risks to the fund and its shareholders of frequent trading in light of the amount of assets held by, or the volume of sales and redemptions through, the financial intermediary; and
4. the confidence the fund (and its chief compliance officer) has in the implementation by an intermediary of trading restrictions designed to enforce fund frequent trading policies or similar restrictions designed to protect the fund from abusive trading practices.

With respect to situations where an intermediary itself imposes restrictions on frequent trading activity by its customers, the adopting release goes on to note that in appropriate circumstances a fund could reasonably conclude that an intermediary’s frequent trading policies sufficiently protect fund shareholders, and could therefore defer to the intermediary’s policies, rather than seek to apply the fund’s policies on frequent trading to shareholders who invest through that intermediary, subject to various prospectus disclosure requirements discussed in the release.

Redemption Fees. The adopting release confirms indications in the proposing release that the SEC does not currently intend to standardize the terms and conditions of redemption fees in order to facilitate their imposition by intermediaries at the beneficial owner level. In so doing, the SEC cites its desire to preserve each fund’s flexibility to fashion policies that are best suited to protect its investors and the lack of consensus among industry participants on the appropriate terms of a uniform redemption fee. The adopting release also confirms that the October 16, 2006 compliance date remains in effect for the redemption fee portion of the Rule.

First Senior Deputy Comptroller of the Currency and Chief Counsel of the OCC, Julie L. Williams, testified before a Subcommittee of the Committee on Government Reform of the House of Representatives concerning the scope of and concerns raised by three OCC Interpretive Letters issued in December 2005 (the "Letters"). See discussion in the December 27, 2005 Alert. Two of the Letters authorize national banks to develop property that the applicable bank already owned (and that is adjacent to the bank’s corporate headquarters) for the purpose of enhancing the property’s value to the bank. Ms. Williams noted that the OCC continues to require that a national bank’s use of bank premises "not be speculative or motivated by [a desire to realize] a gain on the appreciation of the real estate property value." She also stated that the Letters have nothing to do with real estate brokerage or merchant banking. In both cases involving development of bank premises, the banks represented to the OCC that the project would help to rejuvenate downtown, urban areas. In the third Letter, the OCC authorized a national bank to provide financing in the form of an investment in a wind energy project. Ms. Williams testified that the financing was structured as an investment so that the bank could take advantage of tax benefits available to finance alternative sources of energy and that the investment was the functional equivalent of a loan. Ms. Williams emphasized in her testimony that the Letters are specific (and limited to their respective facts), limited in scope, within existing precedent for national banks’ activities and create no safety and soundness concerns.

The SEC CCOutreach Program section of the SEC website now includes materials used at the regional seminars for mutual fund and investment adviser chief compliance officers hosted by examination staff from SEC field offices earlier this year. The materials include the following:

- a checklist of questions covering possible risk areas for use in designing or reviewing compliance programs – the checklist addresses, among other things, potential conflicts of interest and forensic and other testing;

- a discussion of how SEC inspection staff examines annual compliance reviews - the discussion examines nine basic areas of primary focus and possible findings in those areas;

- and a matrix listing risks raised in the case studies that formed the basis for the CCO Outreach regional seminars.

Update – Thursday 5^th October - The hyperlinks to materials from the SEC Regional CCOutreach Seminars discussed in an Other Item of Note that appeared in the most recent edition of the Financial Services Alert no longer appear on the CCOutreach Program section of the SEC website. The links were removed after the Other Item of Note was written. As of today, the seminar materials in question do, however, continue to appear on the SEC website at the following addresses: