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Trading and Capital-Markets Activities Manual

Securitization and Secondary-Market Credit Activities (Continued)
Source: Federal Reserve System 
(The complete Activities Manual (pdf format) can be downloaded from the Federal Reserve's web site)

SELECTED FEDERAL RESERVE SR-LETTERS

Risk Management and Valuation of Retained Interest Arising from Securitization Activities 



BOARD OF GOVERNORS
OF THE
FEDERAL RESERVE SYSTEM
WASHINGTON, D.C. 20551

DIVISION OF BANKING
SUPERVISION AND REGULATION
SR 99-37 (SUP)
December 13, 1999

   TO THE OFFICER IN CHARGE OF SUPERVISION AND APPROPRIATE SUPERVISORY AND EXAMINATION STAFF AT EACH FEDERAL RESERVE BANK AND TO CERTAIN BANKING ORGANIZATIONS SUPERVISED BY THE FEDERAL RESERVE

  
SUBJECT: Risk Management and Valuation of Retained Interest Arising from Securitization Activities 

Significant weaknesses in the asset securitization practices of some banking organizations have raised concerns about the general level of understanding and controls in institutions that engage in such activities. Securitization activities present unique and sometimes complex risks that require the attention of senior management and the board of directors. The purpose of this SR letter is to underscore the importance of sound risk management practices in all aspects of asset securitization. This letter and the attached guidance, developed jointly by the federal banking agencies, should be distributed to state member banks, bank holding companies, and foreign banking organizations supervised by the Federal Reserve that engage in securitization activities. 

Retained interests, including interest-only strips receivable, arise when a selling institution keeps an interest in assets sold to a securitization vehicle that, in turn, issues bonds to investors. Supervisors are concerned about the methods and models banking organizations use to value these interests and the difficulties in managing exposure to these volatile assets. Under generally accepted accounting principles (GAAP), a banking organization recognizes an immediate gain (or loss) on the sale of assets by recording its retained interest at fair value. The valuation of the retained interest is based upon the present value of future cash flows in excess of amounts needed to service the bonds and cover credit losses and other fees of the securitization vehicle.1 Determination of fair value should be based on reasonable, conservative assumptions about such factors as discount rates, projected credit losses, and prepayment rates. Bank supervisors expect retained interests to be supported by verifiable documentation of fair value in accordance with GAAP. In 

Notes: 

1 See Financial Accounting Standard No. 125, ''Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities.''

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the absence of such support, the retained interests should not be carried as assets on an institution's books, but instead should be charged off. Other supervisory concerns include failure to recognize and hold sufficient capital against recourse obligations generated by securitizations, and the absence of an adequate independent audit function. 

The concepts underlying the attached guidance are not new. They reflect the long-standing supervisory principles that i) a banking organization should have in place risk management systems and controls that are adequate in relation to the nature and volume of its risks, and ii) asset values that cannot be supported should be written off. The guidance incorporates fundamental concepts of risk-focused supervision: active oversight by an institution's senior management and board of directors, effective policies and limits, accurate and independent procedures to measure and assess risk, and strong internal controls.2 Bank supervisors are particularly concerned about institutions that are relatively new users of securitization techniques and institutions whose senior management and directors are not fully aware of the risks, as well as the accounting, legal, and risk-based capital nuances, of this activity. The interagency guidance discusses sound risk management, modeling, valuation, and disclosure practices for asset securitization, and complements previous supervisory guidance on this subject.3 

The federal banking agencies will continue to study supervisory issues relating to securitization, including the valuation of retained interests, and may in the future make adjustments to their regulatory capital requirements to reflect the riskiness, volatility, and uncertainty in the value of retained interests. Questions pertaining to this letter should be directed to Tom Boemio, Senior Supervisory Financial Analyst, (202) 452-2982, or Anna Lee Hewko, Financial Analyst, (202) 530-6260.

 Richard Spillenkothen 
Director 

Attachment (36K PDF3) 

Notes: 

2 See SR letters 96-14, ''Risk-focused Safety and Soundness Examinations and Inspections,'' and 95-51, ''Rating the Adequacy of Risk Management Processes and Internal Controls at State Member Banks and Bank Holding Companies.'' 
3 See SR letters 97-21, ''Risk Management and Capital Adequacy of Exposures Arising from Secondary Market Credit Activities,'' 96-40, ''Interim Guidance for Purposes of Applying FAS 125 for Regulatory Reporting in 1997 and for the Treatment of Servicing Assets for Regulatory Capital;'' and 96-30, ''Risk-Based Capital Treatment for Spread Accounts that Provide Credit Enhancement for Securitized Receivables.''

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