Financial Services Alert - September 25, 2012

The proposed Basel III Standardized Approach (the “Standardized Approach”) for calculating risk-weighted assets (which governs the denominator of the calculation of risk-based capital ratios), significantly modifies the capital treatment of residential mortgages which may result in certain types of mortgage products becoming economically unviable.  The Standardized Approach applies to all depository institutions, top tier bank holding companies with $500 million or greater in consolidated assets, and all top tier savings and loan holding companies.  Please see the June 12, 2012 Financial Services Alert for prior coverage of the proposed Basel III standards.

Under the Standardized Approach, residential mortgages are divided into two categories for purposes of risk-weighting.  Category 1 mortgages consist of traditional mortgages not to exceed 30 years in maturity, that have regular periodic payments, are subject to certain underwriting standards and for which the interest rate may not increase beyond certain limits.  A junior-lien mortgage held by the same banking organization may be treated as a Category 1 mortgage if there are no intervening liens and the junior lien meets all of the required criteria of a Category 1 mortgage.  All other mortgages, including all other junior-lien mortgages and nontraditional mortgage products that do not conform to the prescribed terms and standards of Category 1, are classified as Category 2 mortgages.  The risk weights for Category 1 mortgages range from 35% to 100%, depending on the loan-to-value (“LTV”) ratio of the loan at the time of the origination or restructuring of the loan.  The risk weights for Category 2 mortgages range from 100% to 200% depending on the LTV ratio of the loan at the time of the origination or restructuring of the loan.  For purposes of determining the LTV ratio and risk weight of a loan, a banking organization that holds both a first and junior lien on the same property must combine the exposures to such property.  Currently, under the general risk-based capital rules residential mortgages are subject to a 50% or 100% risk weight and under the Basel II standardized approach residential mortgages that meet certain prudential criteria are subject to a 35% risk weight.

The proposed definition of Category 1 mortgages under the Standardized Approach is similar in nature to, but neither identical to nor harmonized with, the proposed definitions of “qualified mortgages” and “qualified residential mortgages” under the Dodd-Frank Act, which relate to legal liability under the ability-to-pay underwriting standards and the retention of risk in mortgage securitizations, respectively.  Please see the July 24, 2012 Consumer Financial Services Alert for prior coverage of the qualified mortgage standard and the April 19, 2011 Financial Services Alert for prior coverage of the qualified residential mortgage standard.

Further, under the Standardized Approach if a banking organization provides a credit enhancing representation or warranty on assets it sold or otherwise transferred to third parties, the banking organization would be required to treat such arrangement as an off-balance sheet guarantee under Section 33 of the Standardized Approach and apply a 100% credit conversion factor to the exposure amount.  This would include loan and other asset sales in which the sale agreement provides for (i) early default clauses, (ii)  premium refund clauses for assets guaranteed by the U.S. government, a U.S. government or a U.S. government-sponsored entity (i.e., Fannie Mae or Freddie Mac); or (iii) the return of assets in instances of fraud, misrepresentation or incomplete documentation.  The 100% credit conversion factor would need to be applied for the duration of such credit enhancing representation or warranty.

The effect of these changes on the capital treatment of residential mortgages will increase the amount of capital that must be held against the exposure to many types of residential mortgage loans.  For example, a loan with an 85% LTV ratio that is currently subject to a 50% risk weight would be subject to a 75% risk weight if classified as a Category 1 loan and a 150% risk weight if classified as a Category 2 loan.  Further, the confluence of the capital treatment under the Standardized Approach and the requirements of the qualified mortgage and qualified residential mortgage rules is expected to effectively create a small range of “plain vanilla” mortgage products that will not be subject to high capital risk weights, risk retention requirements and heightened legal liability under the prescribed underwriting standards.

The credit rating agency Fitch Ratings Ltd. recently stated that, due to the effects of the Standardized Approach, it believes that banks will continue to meet the demand for traditional loan products while passing along the additional cost of capital to borrowers, but that it also believes that “it is unlikely that banks will continue to originate or sell significant volumes of nontraditional mortgage products, thereby reducing [the] availability of credit to many borrowers.

The Mutual Fund Directors Forum issued a report entitled “Practical Guidance for Fund Directors on Oversight of Proxy Voting.”  In broad terms, the report highlights key issues that the board of a registered fund should consider in establishing and overseeing the fund’s proxy voting processes and procedures, and summarizes common proxy voting structures and processes used by registered funds.  The report is based largely on discussions with fund directors and management representatives from fund families of all sizes, representing over 50% of U.S. mutual fund assets under management, and two major proxy voting service providers.

Key Considerations. The report reviews the following issues that the board of a registered fund may want to consider when establishing or reviewing a fund’s proxy voting processes:

• delegation of voting authority to a third party
• use of third party vendors in proxy voting and types of third party services
• involvement of fund managers and other investment professionals
• the process for overriding any proxy voting guidelines
• vote splitting within a fund complex
• engagement with portfolio companies on proxy votes
• conflicts of interest
• voting loaned securities

The report includes various examples of how some boards have addressed these issues.

Approaches to Proxy Voting. The report reviews three general approaches to proxy voting taken by fund boards: (1) retaining all voting authority, (2) delegating voting authority to the fund’s adviser, or (3) delegating voting authority to a third party service provider that votes proxies according to board‑approved voting guidelines.  The report includes an appendix that describes the features and key benefits of common proxy voting models.

Oversight. The report describes threshold decisions a fund board must make in determining how it will oversee the proxy voting processes it has put in place, such as:

• oversight by the full board or a committee
• frequency of review
• reports to be provided, including in-person presentations by management

The Financial Crimes Enforcement Network (“FinCEN”) issued an administrative ruling, FIN-2012-R006 (the “Administrative Ruling”), concerning participation by an “association of financial institutions” in voluntary information sharing programs implemented pursuant to Section 314(b) of the USA Patriot Act (“Section 314(b)”) and the limits on the type of information that may be shared under Section 314(b).  Section 314(b) provides a safe harbor from liability for the voluntary sharing of information by financial institutions or by an association of financial institutions for the purposes of identifying terrorist activity or money laundering.

The Delaware limited liability company (the “LLC”) that made the request to which FinCEN responded in the Administrative Ruling stated that it is wholly-owned by “financial institutions” as defined in 32 CFR §1010.100(t).  The LLC, itself, it said, is not required to have a Bank Secrecy Act (“BSA”)/anti-money laundering (“AML”) compliance program.  The LLC further stated that it had developed a capability to assist in the detection of money laundering or fraud and wants to offer this AML or fraud detection service to qualified “financial institutions” for a fee.  A participant that contributes information used on the LLC database would receive revenue sharing for the use of the data it contributes.  The LLC also stated that participating financial institutions would be restricted from transmitting or disclosing information received from the LLC’s program to other third parties.

FinCEN first concluded in the Administrative Ruling that since the LLC is owned entirely by one or more “financial institutions,” the LLC meets the definition of “association of financial institutions” under Section 314(b).

FinCEN next found that the LLC, its owners and participants in the LLC’s program could avail themselves of the safe harbor under Section 314(b) if the shared information is used for the purposes of identifying money laundering and terrorist financing.  FinCEN concluded in the Administrative Ruling, however, that the Section 314(b) safe harbor for sharing information would not extend to information concerning fraud that is not related to money laundering or terrorist financing.

The SEC issued an order amending interim final temporary Rule 15Ba2-6T under the Securities Exchange Act of 1934 to extend the Rule’s sunset provision until September 30, 2013.  The former deadline was September 30, 2012.  Rule 15Ba2-6T provides a transitional means for municipal advisors to satisfy the registration requirements introduced by the Dodd-Frank Act until the SEC can implement a permanent registration program.  The extension does not otherwise affect the Rule or related Form MA-T.