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Nutter Bank Report, September 2012

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1. New GSE Representation and Warranty Framework Clarifies Put-back Risk
2. Federal Banking Agencies Provide Regulatory Capital Estimation Tool
3. FDIC Issues Guidance on Credit Risk Management for Loan Participations
4. OCC Expects Banks to Manage IORR Credit Risks Similarly to CRE Risks
5. Other Developments: Stress-Tests and Dodd-Frank

1. New GSE Representation and Warranty Framework Clarifies Put-back Risk

The Federal Housing Finance Agency (“FHFA”) announced that Fannie Mae and Freddie Mac are launching a new framework for the enforcement of representations and warranties applicable to conventional home mortgage loans sold or delivered on or after January 1, 2013. According to the FHFA, the objective of the new framework announced on September 11 is to clarify lenders’ repurchase exposure and liability (the so-called put-back risk) on loans purchased by Fannie Mae or Freddie Mac. The representations and warranties currently required from sellers in loan purchase documents will not be altered under the new framework. However, the FHFA’s new framework will require Fannie Mae and Freddie Mac to conduct quality control reviews earlier in the loan process rather than at the time a loan defaults. Quality control reviews will generally be conducted between 30 to 120 days after loan purchase. Fannie Mae and Freddie Mac will also be required to establish consistent timelines for lenders to submit requested loan files for review, evaluate loan files on a more comprehensive basis to ensure a focus on identifying significant deficiencies, and make available more transparent appeals processes for lenders to appeal repurchase requests. Loans will also be subject to automatic repurchase triggers under the new framework. Any loan for which no scheduled payments were made for the first three months after it is acquired by Fannie Mae or Freddie Mac will be subject to a repurchase request. A seller or servicer may appeal the repurchase request by providing documentation that an extenuating circumstance caused the borrower to default.

    Nutter Notes: The new GSE representation and warranty framework will also provide lenders with relief from Fannie Mae’s and Freddie Mac’s enforcement of remedies for breaches of certain representations and warranties, including the obligation to repurchase, for new loan acquisitions that meet specific payment history requirements. For example, lenders will be relieved of repurchase obligations if the borrower has made on-time payments during the first 36 months after Fannie Mae or Freddie Mac acquired the loan, or the borrower was current as of the 60th month with no more than two 30-day delinquencies and no 60-day delinquency during the first 36 months. For Home Affordable Refinance Program (HARP) loans, lenders will be relieved of repurchase obligations if the borrower has made on-time payments during the first 12 months after Fannie Mae or Freddie Mac acquired the loan. To be eligible for representation and warranty relief, the loan also must not have been subject to a forbearance agreement, repayment plan, or otherwise have been modified from its original terms during the first 12, 36, or 60 months, as applicable, based on the acceptable payment history described above. In addition, with the exception of temporary subsidy buy-down arrangements permitted by the loan purchase documents, neither the seller, servicer nor any third party may escrow or advance funds to be used for payment of any monthly installment, principal, interest, or other charge payable under the terms of the loan. Fannie Mae and Freddie Mac are required to provide additional information about exclusions for representation and warranty relief, such as violations of state, federal and local laws and regulations. 

2. Federal Banking Agencies Provide Regulatory Capital Estimation Tool

The federal bank regulatory agencies have made a regulatory capital estimation tool available on their respective websites that allows community banking organizations and others to evaluate the recently published proposals to change the regulatory capital rules. The capital estimation tool announced on September 24 may be used to analyze the potential effects on capital ratios of the agencies’ Basel III Notice of Proposed Rulemaking and Standardized Approach Notice of Proposed Rulemaking issued on June 7. The Basel III proposal focuses primarily on strengthening the level of regulatory capital requirements and improving the quality of capital. This Basel III proposal would establish more conservative standards for including an instrument in regulatory capital. The Standardized Approach proposal includes a number of enhancements to the risk sensitivity of the agencies’ capital standards. The Standardized Approach proposal also would introduce disclosure requirements that would apply to top-tier banking organizations with $50 billion or more in total assets, including disclosures related to regulatory capital instruments. The public comment period for the proposed rules ends on October 22, 2012.

    Nutter Notes: The Basel III proposal would impose a new common equity Tier 1 minimum capital requirement, a higher minimum Tier 1 capital requirement, and, for banking organizations subject to the advanced approaches capital rules, a supplementary leverage ratio that incorporates a broader set of exposures in the denominator measure. The proposal would also apply limits on a banking organization’s capital distributions and certain discretionary bonus payments if the banking organization does not hold a specified amount of common equity Tier 1 capital in addition to the amount necessary to meet its minimum risk-based capital requirements. The Standardized Approach proposal would change the agencies’ general risk-based capital requirements for determining risk-weighted assets to enhance risk sensitivity. The proposal would change the methodologies for determining risk-weighted assets for residential mortgages, securitization exposures, and counterparty credit risk. The proposal also would impose alternatives to credit ratings for calculating risk-weighted assets for certain assets, as required by the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (“Dodd-Frank Act”). The changes in the Standardized Approach are proposed to take effect on January 1, 2015.

3. FDIC Issues Guidance on Credit Risk Management for Loan Participations

The FDIC has issued guidance to all FDIC-supervised banks and savings associations on effective credit risk management practices for purchased loan participations. The guidance, published on September 12 in FDIC Financial Institution Letter No. FIL-38-2012, warns that over-reliance on lead institutions by purchasing banks in loan participations has, in some instances, caused significant credit losses and contributed to bank failures, particularly for loans to out-of-territory borrowers and obligors involved in industries unfamiliar to the purchasing bank. The guidance recommends that banks apply the same underwriting and loan administration practices to loan participations as if the purchaser were directly originating the loan. According to the guidance, banks should implement an appropriate credit risk management framework before purchasing a participation loan. The credit risk management framework should include effective loan policy guidelines, written loan participation agreements, independent credit analysis and review procedures, and a comprehensive due diligence process. The guidance reiterates the FDIC’s support of banks’ efforts to meet the credit needs of their communities in part through loan participations and the FDIC’s expectations that institutions exercise sound judgment and strong underwriting when purchasing loan participations.

    Nutter Notes: The guidance recommends that loan policies outline procedures for originating and purchasing participation loans, require thorough borrower due diligence at origination and over the life of the participation, and mandate an assessment of the purchasing bank’s contractual rights and obligations. The guidance also recommends that banks consider including commitment limits for aggregate purchased participations, out-of-territory participations, and loans originated by individual lead institutions. Written loan participation agreements should fully describe the lead institution’s responsibilities, establish requirements for obtaining timely borrower credit information, address remedies upon default, and outline dispute resolution procedures, according to the guidance. In terms of credit and collateral analysis, the guidance urges banks to perform the same degree of independent analysis as if they were the originator. Finally, the guidance recommends that banks perform extensive due diligence of participations involving an out-of-territory loan or credit facility to a borrower in an unfamiliar industry, including review and monitoring of the obligor, source of repayment, market conditions, and potential vulnerabilities.

4. OCC Expects Banks to Manage IORR Credit Risks Similarly to CRE Risks

The OCC recently issued guidance to national banks and federal savings associations on credit risk management practices for investor-owned, one- to four-family residential real estate (“IORR”) lending where the primary repayment source for the loan is rental income. The guidance, published on September 17 in OCC Bulletin No. OCC 2012-27, recommends consistent risk management practices for IORR lending and summarizes the applicable requirements for regulatory capital and call reports for IORR lending. The OCC recognizes that some institutions manage IORR loans in a similar manner to owner-occupied one- to four-family residential loans. However, the OCC takes the view that the credit risk presented by IORR lending is similar to that associated with loans for income-producing commercial real estate (“CRE”). Because of this similarity, the OCC said that it expects banks to use the same types of credit risk management practices for IORR lending that are used for CRE lending. The guidance clarifies that the OCC’s credit risk management expectations do not change the regulatory capital, regulatory reporting, and Home Owners’ Loan Act requirements for IORR.

    Nutter Notes: The guidance recommends that institutions have IORR credit risk management policies and processes in place that cover loan underwriting standards, loan identification and portfolio monitoring expectations, allowance for loan and lease losses methodologies (ALLL), and internal risk assessment and rating systems. The guidance says that IORR lending should follow the federal banking agencies’ uniform regulations on real estate lending, including underwriting standards, portfolio administration, and supervisory loan-to-value limits. The OCC recognizes that borrowers may convert homes into rental units without notifying their lenders. The guidance recommends that institutions make every effort to properly identify, monitor, and structure IORR loan relationships. In terms of ALLL methodologies, the guidance provides that individually impaired IORR loans should be evaluated in accordance with ASC 310-10 (formerly FAS 114), and that loans that are not individually impaired may be evaluated as an ASC 450-20 (formerly FAS 5) pool. The OCC also expects banks to have credit risk management systems that produce accurate and timely risk ratings. A rating system similar to that used for CRE lending is generally appropriate for an IORR portfolio, according to the guidance.

5. Other Developments: Stress-Tests and Dodd-Frank

  • Federal Banking Agencies Consider Changes to Stress-Test Implementation Timeline

The federal banking agencies announced on August 27 that they are considering changes to the implementation timeline for the annual company-run stress test requirements required by the Dodd-Frank Act. The changes would delay implementation until September 2013 for bank holding companies, state member banks, and savings and loan holding companies with between $10 billion and $50 billion in total consolidated assets.

    Nutter Notes: The agencies issued proposed rules in December 2011 to implement the enhanced regulatory capital standards and early remediation requirements established under the Dodd-Frank Act. The proposal would generally require depository institutions and depository institution holding companies with more than $10 billion in total consolidated assets to comply with the requirements to conduct a company-run stress test annually after the final rule becomes effective.

  • GAO Reports on Effects of Dodd-Frank Act on Community Banks

A report issued by the Government Accountability Office (“GAO”) on September 13 acknowledged that some of the Dodd-Frank Act’s provisions impose additional requirements on community banks and credit unions that could affect them disproportionately relative to larger banks, but that the full impact of the Dodd-Frank Act on community banks remains uncertain.

    Nutter Notes: The report notes that significant provisions of the Dodd-Frank Act, such as the mortgage reforms, have not yet been fully implemented and may impose additional requirements and costs on all banks. The report concluded that it is difficult to know for certain which provisions will impact community banks disproportionately because rules implementing mortgage reforms and other key provisions of the act have not been finalized.

Nutter Bank Report

Nutter Bank Report is a monthly electronic publication of the Banking and Financial Services Group of the law firm of Nutter McClennen & Fish LLP. Chambers and Partners, the international law firm rating service, has ranked Nutter’s Banking and Financial Services practice among the top banking practices in the nation. The 2011 Chambers and Partners review says that “broad platform of legal expertise and experience” in the practice “helps clients manage challenges and balance risks while delivering strategic solutions.” Clients praise Nutter banking lawyers as “very responsive and detail-oriented.” Visit the U.S. rankings at The Nutter Bank Report is edited by Matthew D. Hanaghan. Assistance in the preparation of this issue was provided by Lisa M. Jentzen. The information in this publication is not legal advice. For further information, contact:

Kenneth F. Ehrlich
Tel: (617) 439-2989

Michael K. Krebs 
Tel: (617) 439-2288

This update is for information purposes only and should not be construed as legal advice on any specific facts or circumstances. Under the rules of the Supreme Judicial Court of Massachusetts, this material may be considered as advertising.

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