In its letter to the ICI, the Staff said that its no-action relief would remain in effect until the SEC determines whether to modify Rule 2a 7 and remove all references in the rule to NRSROs, as required by Section 939A of the Dodd-Frank Wall Street Reform and Consumer Protection Act (discussed in the July 28, 2010 Alert).  Until such modifications to Rule 2a 7, the Staff said that a money market fund must continue to comply with its obligations for determining and monitoring whether its securities, other than unrated asset backed securities, are or continue to be eligible securities for purposes of Rule 2a-7 as in effect before the February 2010 amendments to Rule 2a 7 took effect on May 5, 2010.  The Staff said that a money market fund may continue to acquire unrated asset-backed securities as permitted by the February 2010 amendments.  (Prior to the February 2010 amendments, a money market fund could acquire an asset-backed security only if the security was a rated security for purposes of Rule 2a-7.)

The ANPR describes the areas in the Agencies’ risk-based capital standards where the Agencies rely on credit ratings, as well as the Basel Committee on Banking Supervision’s (the “Basel Committee”) recent amendments to the Basel Accord.  Specifically, the Agencies’ capital rules reference credit ratings issued by nationally recognized statistical rating organizations in four general areas: (1) the assignment of risk weights to securitization exposures under the general risk-based capital rules and advanced approaches rules; (2) the assignment of risk weights to claims on, or guaranteed by, qualifying securities firms under the general risk-based capital rules; (3) the assignment of certain standardized specific risk add-ons under the Agencies’ market risk rule; and (4) the determination of eligibility of certain guarantors and collateral for purposes of the credit risk mitigation framework under the advanced approaches rules.  In addition, the Basel “standardized” approach for credit risk relies extensively on credit ratings to assign risk weights to various exposures.

Through the ANPR, the Agencies are seeking comments on alternative standards of credit-worthiness that could be used for purposes of their risk-based capital standards.  The ANPR notes that the Agencies are considering a wide range of approaches, including (a) developing risk weights for exposure categories based on objective criteria (such as the type of obligor and certain characteristics of the exposure) similar to the risk bucketing approach of the general risk-based capital rules, and (b) developing broad qualitative and quantitative credit-worthiness standards (such as credit spreads or debt-to-equity ratios) that banking organizations could use to measure the credit risk associated with exposures within a particular exposure category.

In evaluating these approaches, the Agencies noted that they will, to the extent practicable, consider whether any such approach would: (i) appropriately distinguish the credit risk associated with a particular exposure within an asset class; (ii) be sufficiently transparent, replicable, and defined to allow banking organizations of varying size and complexity to arrive at the same assessment of credit-worthiness for similar exposures and to allow for appropriate supervisory review; (iii) provide for the timely and accurate measurement of negative and positive changes in credit-worthiness; (iv) minimize opportunities for regulatory capital arbitrage; (v) be reasonably simple to implement and not add undue burden on banking organizations; and (vi) foster prudent risk management.  The ANPR requests comments on the advantages and disadvantages of the proposed approaches, as well as any suggestions for other approaches that would meet the stated credit-worthiness standard.

The ANPR provides a detailed discussion of how the approaches might be implemented with respect to certain specific exposure categories, including: (1) sovereign exposures; (2) public sector entity (“PSE”) exposures; (3) bank exposures; and (iv) corporate exposures.  For example, the ANPR discusses the possibility of expanding the general risk-based capital treatment of these exposures to the other risk-based capital regimes.  The ANPR also discusses the possibility of using certain key financial, economic and market indicators and measures to determine the correct risk weighting for such exposures, or assigning exposures to one of a limited number of risk weight categories based on an assessment of the exposure’s probability of default or expected loss.

With respect to securitization exposures, the Agencies are seeking comment on a number of proposals, including: (a) using the risk-based capital rules in effect prior to the implementation of the “recourse rule,” which would eliminate all references to credit ratings and result in all securitization exposures receiving the same risk weight regardless of the amount of subordination in the securitization structure; (b) requiring banks to “gross-up” any such exposure by maintaining capital against its securitization exposure as well as all more senior exposures; (c) adopting the Basel Committee’s approach to calculating capital requirements for securitization exposures that is based on the level of subordination and the type of underlying exposures and which uses a “concentration ratio” (equal to the sum of the notional amounts of all the tranches divided by the sum of the notional amounts of the tranches junior to or pari passu with the tranche in which the position is held including that tranche itself); and (d) designing a risk-weighting approach based on a supervisory formula.  In addition, with respect to guarantees and collateral, the ANPR notes the possibility of the Agencies incorporating into the recognition of collateral and guarantees some of the credit-worthiness standards discussed above for sovereign, PSE, bank and corporate exposures.

The ANPR requests comments on all of the potential approaches, and commenters are asked to provide quantitative and qualitative support and/or analysis for proposed alternative methods.  The ANPR notes that the Agencies recognize that a “more refined differentiation of credit-worthiness may be achievable only at the expense of greater implementation burden,” and therefore are also seeking comment on the feasibility of and burden associated with each of the various alternative standards for banking organizations of varying size and complexity. 

Before approving the issuance of the ANPR, several members of the FDIC’s Board of Directors expressed concern about completely eliminating the use of credit ratings.  In this regard, the ANPR notes that the Agencies are “interested in whether development of alternatives to the use of credit ratings would involve, in most circumstances, cost considerations greater than those under the current regulations.”

Eliminating the use of credit ratings will also further delay implementation in the U.S. of the so-called Basel II “Standardized Approach” and revisions to the market risk rules.  Both the Standardized Approach, a simpler version of Basel II that is expected to be optional for all U.S. banks that are not required to adopt the Basel II advanced approaches, and the proposed revisions to the market risk rules, use external ratings.  Efforts to finalize these initiatives have now been delayed indefinitely until the Agencies determine appropriate alternatives to the use of such external ratings.

Comments on the ANPR are due within 60 days after its publication in the Federal Register, which is expected shortly.  The OTS is expected to join the Agencies in issuing the ANPR upon clearance by the Office of Management and Budget.

The Alert will continue to monitor this area and provide updates on material developments as they occur.

PROSPECTUS DISCLOSURE

The Staff observed that some funds provide generic disclosures about derivatives that are either too abbreviated or too detailed and technical, to be useful to investors.  The Staff indicated that all funds that use or intend to use derivative instruments should assess the accuracy and completeness of their disclosures and should (i) only reference derivatives in a fund’s principal investment strategies if they are expected to be used in connection with such strategies; (ii) describe the purpose that the derivatives are intended to serve in a fund’s portfolio, e.g. hedging, speculation, or as a substitute for investing in conventional securities; and (iii) disclose the extent to which a fund expects to use derivatives.  In addition, the Staff noted that disclosure about a fund’s principal risks that addresses derivatives should similarly be tailored to the types of derivatives used by the fund, the extent of their use, and why they are used.  The Staff suggested that a fund review its use of derivatives annually when it updates its registration statement and assess whether it needs to revise its principal strategy and principal risk disclosures that address derivatives.

SHAREHOLDER REPORTS

The Staff also provided observations regarding derivatives disclosure in shareholder reports.  The Staff observed that some funds whose financial statements appear to reflect significant derivatives exposure do not discuss the effect of those derivatives on fund performance.  The staff noted that Management’s Discussion of Fund Performance (MDFP) included in annual shareholder reports should be consistent with operations reflected in a fund’s financial statements, and a fund whose performance was materially affected by derivatives should discuss that fact, whether or not derivatives are reflected in the portfolio schedule at the close of the fiscal year.  With regard to financial statements themselves, the Staff noted specific improvements that funds should make in certain disclosures required by FASB Accounting Standards Codification Topic 815: Derivatives and Hedging.  In addition, the Staff stated that because an over-the-counter derivative is subject to the risk of nonperformance by the counterparty, the staff views identification of the counterparty to an over-the-counter derivative as a material component of the description of that position provided in a fund’s schedule of investments.

The CFI, said the FDIC, will conduct continuous reviews and oversight of bank holding companies with more than $100 billion in assets and will examine any nonbank financial companies designated as systemically important by the Financial Stability Oversight Council created by the Dodd-Frank Act.  The CFI is also the FDIC unit responsible for using the FDIC’s powers under the Dodd-Frank Act to implement orderly liquidations of bank holding companies and nonbank financial companies that fail.  The FDIC said that the establishment of the CFI is the first step in ending the presumption of “too big to fail.”