regulators are taking another look at securitizations

Four of the top bank regulatory agencies in the U.S. are taking a closer look at how lenders set aside capital for the loans they sell as securities to investors.

The Federal Deposit Insurance Corp., the Office of the Comptroller of the Currency, the Office of Thrift Supervision and the Federal Reserve Board are looking at eliminating a limit on the capital requirements for loans kept by lenders after they sell them as securities.

As a result, lenders could be looking at having to up the amount of capital they keep on hand to safeguard against loans going bad.

The federal agencies late last week were expected to send out a proposed regulatory change governing capital requirements for a 90-day comment period. Officials at the agencies expect bank officials, academics and government employees will constitute most of the responses.

‘Residuals’

At issue is how much of a loan portfolio a lender keeps after a securitization and how much they have in capital.

When a lender securitizes a loan portfolio, it can keep a small percentage of the portfolio as a residual. But it also has to have capital on hand as a hedge against possible default of the portfolio. Currently, the capital requirement is 8% of the total securitization or less, depending on how big of a portion the lender keeps.

If the lender keeps a residual of less than 8% of the securitization, say, $5 million on a $100 million securitization, then it has to have $5 million in capital.

What’s grabbed the attention of regulators is lenders holding more than 8% of the securitization but having capital on hand equal only to 8%

“There are no special regulations for residuals for securitizations,” said Mark Schmidt, the associate director in the division of supervision for the FDIC. “The problem has been where (lenders) write a $100 million deal and they keep $15 million. So then you have an $8 million capital requirement on a $15 million deal. It is highly risky.”

New regulation would eliminate the 8% cap, forcing the lenders to maintain as much capital as they hold in residual loans.

“Where volatility came back and became a problem, the current cap standards proved to be not high enough,” Schmidt said.

There are about 100 institutions that keep residuals on their books, Schmidt said, though the current cap covers most of the residuals.

“We have a lot of securitization deals where the retained interest is small,” Schmidt said.

Investor Protection

Subprime loans, which are made to people with less-than-perfect credit and carry higher risks, are part of the issue. With subprime securitizations, Wall Street investors want the lenders to hold more of the loans they securitize.

“Your residual is the protection for the investors,” Schmidt said.

About a dozen institutions nationwide would be affected by the new regulation, Schmidt said.

One Orange County financial company that could fall under new regulation is Irvine-based Westcorp and its bank subsidiary, Western financial Bank, according to one industry insider. Westcorp is the fourth-largest securitizer of auto loans in the nation, behind the finance arms of the big automakers: Chrysler Financial Corp., General Motors Acceptance Corp. and Ford Motor Credit Co.

Lee Whatcott, Westcorp’s chief financial officer, said he hasn’t seen the proposed regulation and declined to comment.

There are other Orange County lenders, including many in the subprime industry, that perform securitizations. But most of them are not regulated by the agencies pushing the new rule.

Past Trouble

Recent bank failures have FDIC officials alarmed. Take the case of West Virginia’s First National Bank of Keystone, which was closed last September in what officials call the largest bank failure since the savings and loan crisis. The bank went from $171 million in originated loans in 1995 to $940 million in loans three years later. But regulators closed the bank citing internal control and audit deficiencies after it lost $515 million in assets.

In November, state and federal banking regulators had to close down Woodland Hills-based Pacific Thrift and Loan, another lender that dove into the subprime market.

Of the 8,500 institutions the FDIC insures, 150 have significant exposure to subprime loans and those institutions account for 20% of problem institutions, according to media reports.

Banking regulators also have their hands full with the increased number of commercial real estate and construction lending divisions at smaller Banks. Agencies have issued several warnings to Banks regarding the capital requirements for those types of loans, because the cyclical real estate market is riding a high and Banks are making more loans.

Construction Funding

One example is Brea-based Pacific Western National Bank, which moved its operations here last year to take advantage of the growing Orange County economy. Pacific Western’s primary lending operations have been in construction lending. The bank’s construction loan portfolio went from $16.2 million at the end of 1998 to $29.5 million at the end of 1999.

Regulators are worried that the increased activity industry-wide could lead to a big bust when the real estate market heads south. They are trying to get banks to either slow their real estate lending or to hold more in capital.