Proposed Definitions of Higher-Risk Consumer and C&I Loans and Securities under FDIC Large Bank Pricing

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1 Proposed Definitions of Higher-Risk Consumer and C&I Loans and Securities under FDIC Large Bank Pricing On March 20, the FDIC Board proposed for public comment revised definitions of subprime consumer loans and leveraged commercial loans and securities, henceforth termed higher-risk consumer loans and securities and higher-risk C&I loans and securities for use in the Large Bank Pricing (LBP) model (see Consistent with the second extension of transitional Call Report filing for these two items, the new definitions will go into effect on October 1, Comments on the proposal are due May 29. The proposed definitions differ significantly from those under the current rule. The following table compares what has been proposed to the definitions under the current rule. Current Definition Proposed Definition Higher-Risk Consumer Loans Subprime loans include loans made to borrowers that display one or more of the following credit risk characteristics (excluding nontraditional mortgage loans) at origination or upon refinancing: two or more 30-day delinquencies in the last 12 months, or one or more 60-day delinquencies in the last 24 months; judgment, foreclosure, repossession, or charge-off in the prior 24 months; bankruptcy in the last five years; or debt service-to-income ratio of 50 percent or greater, or otherwise limited ability to cover family living expenses after deducting total monthly debt-service requirements from monthly income. A consumer loan or security will be classified as higher risk if, as of origination or refinance, the probability of default (PD) within two years exceeds 20 percent. A loan that meets the definitions of a higher-risk consumer loan and a nontraditional mortgage at origination will be reported as the latter. The loan would later be reported as a higher-risk consumer loan if it ceases to meet the nontraditional mortgage definition. Banks must also report the balance of all consumer loans, including those with PDs below the 20 percent threshold, stratified by 10 product types and 12 PD bands (see Appendix), and indicate whether the PDs were derived using scores and default rate mappings provided by a third party vendor or an internal approach. The FDIC will use this data to determine whether the PD threshold should be changed in the future. The proposal provides specifications for PD estimation, including how PD is defined and the period over which it is estimated. PD estimation must reflect the average two-year stress period performance of loans across a range of remaining maturities, as opposed to within the first two years of origination. The FDIC may alter the specifications without public notice and comment. The FDIC may, without public notice and comment, alter the 20 percent PD threshold, but would provide a quarter s notice. When a bank acquires a consumer loan or security, it must determine whether the asset meets the higher-risk definition using the origination criteria and analysis performed by the original lender. If this data is unavailable, the bank must obtain recent, refreshed data from the borrower or an appropriate third-party. March 20, 2012

2 Higher-Risk C&I Loans Leveraged loans include all commercial loans (funded and unfunded), except real estate loans, with an original amount greater than $1 million and securities issued by commercial borrowers, except those classified as trading book, that meet any of the following conditions at origination or renewal: Loans or securities where borrower s total or senior debt to trailing twelve-month EBITDA 6 (i.e., operating leverage ratio) is greater than 4 or 3 times, respectively. For purposes of this calculation, the only permitted EBITDA adjustments are those adjustments specifically permitted for that borrower in its credit agreement; or Loans or securities designated as highly leveraged transactions (HLT) by a syndication agent. Higher-risk C&I loans and securities include: Commercial loans (funded or unfunded, including irrevocable and revocable commitments) with an original amount greater than $5 million if the conditions specified in (a) or (b) below are met as of origination, or, if the loan has been refinanced, as of refinance, and the loan does not meet the asset based lending (ABL) exclusion or the floor plan line of credit exclusion. (a) (i) The purpose of any of the borrower s debt (whether owed to the evaluating bank or another lender) incurred within the previous seven years was to finance a buyout, acquisition or capital distribution and such debt was material; and (ii) The ratio of the borrower s total debt to trailing twelve-month EBITDA (i.e., operating leverage ratio) is greater than 4 or the ratio of the borrower s senior debt to trailing twelve-month EBITDA (i.e., operating leverage ratio) is greater than 3; or (b) Any of the borrower s debt (owed to the evaluating bank or to another lender) is designated as a highly leveraged transaction (HLT) by a syndication agent. All securities held by the evaluating bank that are issued by a commercial borrower, if the conditions specified in (a) or (b) above are met, except securities classified as trading book. Debt to finance a buyout, acquisition, or capital distribution would be deemed material if (1) it results in at least a 20 percent increase within 12 months in the total funded debt of the borrower, or (2) the borrower had no funded debt before the debt was incurred. The higher-risk balance would exclude the maximum amount recoverable from the U.S. Government, its agencies, or governmentsponsored agencies under guarantee or insurance provisions. It would also exclude loans fully secured by cash collateral in a savings or time deposit held by the bank if (1) there is a signed collateral assignment that is irrevocable for the remaining loan/commitment term, and (2) a hold is in place on the account that alerts employees to an attempted withdrawal. For a revolving line of credit, the cash collateral must equal or exceed the total funded and unfunded loan balance. No other liquid asset collateral is accepted for this purpose. To satisfy the ABL or floorplan line of credit exclusions, a loan must be (1) well secured by self-liquidating collateral (accounts receivable and inventory) and (2) originated by a bank that can show a history of strong risk management and internal controls over such loans. When a bank acquires a loan or security, it must determine whether the asset meets the higher-risk definition using the origination criteria and analysis performed by the original lender. If this information is not available, the bank must obtain recent refreshed data from the borrower or an appropriate third-party. Page 2 of 5

3 Timing of Classification as Higher-Risk Assets / Refinance Consumer loans are to be classified as subprime (or not) and commercial loans and securities as leveraged (or not) at origination or refinance. Nontraditional Mortgage Loans Consumer and C&I loans and securities are to be classified as higher-risk (or not) at origination or refinance. For consumer loans, a refinance is an extension of new credit or additional funds on an existing loan but only if funding is increased by at least 10 percent or replacement of a loan with a new or modified loan. For a line of credit, this means at least a ten percent increase in the size of the credit line; it does not mean a disbursement, draw or convenience checks within the existing credit line. Consolidation of multiple loans, change in the interest rate, and rescheduling of principal or interest to create or increase a balloon payment to extend the loan term by more than six months all count as refinancings. Extension of the maturity date is not, per se, a refinance. Nor is deferral of payments consistent with the terms of the loan agreement (as is common for student loans). Replacing an existing credit card after expatriation or for security or technology reasons is not a refinance. Any non-temporary credit card line increase not just above 10 percent that is not a TDR is a refinance. For C&I loans, a refinance includes an increase in the master commitment of a line of credit (not including adjustments to sublimits under the master commitment), disbursement of additional money other than amounts already committed, extension of the maturity, rescheduling of principal or interest payments to create or increase a balloon payment, substantial release of collateral, consolidation of multiple existing obligations, or change in the interest rate. Any other modification does not constitute a refinance. Modification of a consumer/c&i loan that results in reclassification as a TDR is not a refinance that triggers reclassification of the loan. Nor is a modification of a loan pursuant to a government program (e.g., Home Affordable Modification Program, Home Affordable Refinance Program, Servicemembers Civil Relief Act). Nontraditional mortgage loans includes all 1-4 family residential loan products that allow the borrower to defer repayment of principal or interest, including all interest-only products, teaser rate mortgages, and negative amortizing mortgages, with the exception of home equity lines of credit (HELOCs) and reverse mortgages. A mortgage loan is no longer considered a nontraditional mortgage once the teaser rate has expired. An interest only loan is no longer considered nontraditional once the loan begins to amortize. The FDIC will monitor future rulemakings regarding Qualified Residential Mortgages (QRMs) and the capital treatment of nontraditional mortgage loans to determine whether this definition should be changed in the future. Page 3 of 5

4 Securitizations of Higher-Risk Consumer or C&I Loans, or Nontraditional Mortgages A securitization of consumer, C&I or residential mortgage loans, except those classified as trading book securities, is to be included in the balance reported for higher-risk consumer loans and securities, higher-risk C&I loans and securities, or nontraditional mortgages, respectively, if more than 50 percent of the underlying collateral fits the corresponding definition. A bank is required to use information that is reasonably available to a sophisticated investor in reasonably determining whether a securitization meets the 50 percent threshold. Guidelines: Such information includes, but is not limited to, offering memorandums, indentures, trustee reports, and requests for information from servicers, collateral managers, issuers, trustees, or similar third parties. When determining whether a revolving trust or similar securitization meets the 50 percent threshold, a bank can use established criteria, model portfolios, or limitations published in the offering memorandum, indenture, trustee report or similar documents. Sufficient information necessary to make a definitive determination may not, in every case, be reasonably available. In such cases, the bank may exercise judgment and the FDIC may review and audit such determinations. Somewhat more stringent requirements apply when a bank acquires loans or securities from another entity on a programmatic or recurring basis. This definition does not consider risk mitigants or securitization trenching because the FDIC believes that the performance of a securitization is highly correlated with the performance of the underlying assets, even when the securitization contains terms or conditions intended to reduce risk. A bank is permitted to evaluate the underlying assets individually i.e., not 100 percent in or out if it has access to the necessary information. Once the bank does this for a securitization, it cannot reverse and go to a 50 percent test. Higher-risk consumer loan securitizations are not to be reported in the PD distribution. The proposal states that the revised definitions the FDIC does not intend for the proposed changes in definitions to result in the FDIC collecting higher or lower deposit insurance assessment revenue from affected banks as a group, although it may result in individual banks paying higher or lower assessments. The FDIC will adjust the minimum and maximum cutoff values for the higher-risk assets to Tier 1 capital and reserves ratio in the LBP model to make the changes revenue-neutral. Page 4 of 5

5 Appendix Demonstration Consumer Loan PD Call Report Form Outstanding Balance of Consumer Loans by Two-Year Probability of Default (PD) Two-year PD Product All nontraditional residential mortgages 1 Closed end loans secured by first liens on 1-4 family residential properties 2 Closed end loans secured by junior liens on 1-4 family residential properties 3 Revolving, open-end first liens and credit lines secured by 1-4 family residential properties 4 Revolving, open-end junior liens and credit lines secured by 1-4 family residential properties 5 Credit cards 6 Automobile loans 7 Student loans 8 Other consumer loans (single payment and installment) and revolving credit plans other than credit cards 9 Consumer leases 10 Totals 1% 1 4% 4 6% 7 10% All reported amounts exclude the amounts recoverable from the U.S. government, its agencies, or governmentsponsored agencies under guarantee or insurance provisions, as well as loans that are fully secured by cash collateral. 1 As defined in the Large Bank Pricing rule. 2 Schedule RC-C item (c)(2)(a), excluding loans reported as nontraditional residential mortgages. 4 Part of Schedule RC-C item 1(c)(1), "revolving, open-end loans secured by 1-4 family residential properties and extended under lines of credit." 5 The portion of Schedule RC-C item 1(c)(1) not reported as revolving, open-end senior liens. 6 Schedule RC-C item 6(a) 7 Schedule RC-C item 6(c) 8 Part of Schedule RC-C item 6(d) "other consumer loans" 9 The portion of Schedule RC-C item 6(d) not reported as student loans, plus item 6(b) "Other revolving credit plans." 10 Schedule RC-C item 10(a) 10 14% 14 16% 16 18% 18 20% 20 22% 22 26% 26 30% > 30% Page 5 of 5