There have been a series of seemingly technical announcements and requests for public comment coming from the regulatory community in the past few months. While individually they may seem relatively insignificant, taken together they represent a sea change in how regulators measure and monitor bank performance and risk. One of these that we are monitoring and upon which we intend to comment is a proposed change to the Classification of Commmercial Credit Exposures.

Originally issued in 1938, regulators are proposing to abandon the current borrower risk rating assignment system and replace it with a two-axis risk classification schema that seems to mitigate inherent borrower risk by allowing treatment of facility risk severity as a second factor in credit exposure analysis. The proposed framework, if adopted, would apply to all regulated financial institutions and their operating subsidiaries.

The proposal seeks enable banks to compensate for failed borrower risk, even defaulted ones, by mitigating the risk of a loan against a facility loss factor in the equation. This allows credit guarantees and enhancements to enter the rating process in effect creating an "on the balance sheet" loan stratification structure that will need to be monitored, analyzed and examined on a regular basis. The regulators seem to be commingling the obligors default probability P(D) and loss given default (LGD), to borrow from Basel II terminology, to devise a rating formula that ultimately alters the rules used to perform capital adequacy testing.

The net effect of this proposed "two-axis" approach seems to be the enablement of a new category of a sub-prime strata for on the books business loans that have degraded significantly since inception. This trend confirms other observations we have made regarding the general industry trend. More, it appears to us that this is may be a lead indicator of more hard times and workouts expected ahead.

We expect that under this proposed schema, the new dance step for degrading obligors will be to first slide sideways from a pass rating to a default rating with credit support maintaining a near lossless facility rating prior to descending into a sub-prime facility tier. If adopted, we believe it is in the national interest for banks report these sub-prime tiers in detail in their call reports possible even as separate elements so P(D), LGD, M and EAD rates can be benchmarked by loan category and facility tier.

We are particularly keen to see if the regulators will be require banks to report the amounts of loans that transitioned from one facility tier to another per reporting period as well as the quarterly amounts written down or placed into non-accrual status as part of executing any downshift to a sub-prime level.

The bottom line seems to be that banks may soon have yet another vehicle to shed what IRA is told is a growing inventory of sub-prime class underperforming loans. It certainly presents interesting alternatives to relying on derivatives and ABS packages to shed the risky obligors out of their capital adequacy calculations, an approach that has left regulators frantic due to the opacity of these very structures.

Speaking of which, there are parallel regulatory agency dockets on ABS lending rules changes and other rules proposals aimed at encouraging banks to consider the use of derivatives as well. So the big question is this: Are the powers that be preparing US bank C&I; infrastructure to accommodate some future anticipated shock event?

Basel II Profile:Washington Mutual Bank, FA

Washington Mutual Bank is the lead unit of Washington Mutual Inc. (NYSE:WM) and accounts for 88% of the assets of the consolidated group. Below is the profile for WaMu taken from the IRA Bank Monitor. Notice that WaMu, like all thrifts, cannot seem to fill out the FDIC call report correctly regarding aggregate loan portfolio maturity, so we are not able to provide the WAM we usually calculate for all FDIC insured commercial banks.

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