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Trading and Capital-Markets Activities Manual

Capital-Markets Activities: 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)

ACCOUNTING ISSUES 

Asset securitization transactions are frequently structured to obtain certain accounting treatments, which in turn affect reported measures of profitability and capital adequacy. In transferring assets into a pool to serve as collateral for ABS, a key question is whether the transfer should be treated as a sale of the assets or as a collateralized borrowing, that is, a financing transaction secured by assets. Treating these transactions as a sale of assets results in their being removed from the banking organization's balance sheet, thus reducing total assets relative to earnings and capital, and thereby producing higher performance and capital ratios. Treating these transactions as financings, however, means that the assets in the pool remain on the balance sheet and are subject to capital requirements and the related liabilities to reserve requirements. 

CAPITAL ADEQUACY 

As with all risk-bearing activities, institutions should fully support the risk exposures of their securitization activities with adequate capital. Banking organizations should ensure that their capital positions are sufficiently strong to support all of the risks associated with these activities on a fully consolidated basis and should maintain adequate capital in all affiliated entities engaged in these activities. The Federal Reserve's risk-based capital guidelines establish minimum capital ratios, and those banking organizations exposed to high or above average degrees of risk are, therefore, expected to operate significantly above the minimum capital standards. 

The current regulatory capital rules may not fully incorporate the economic substance of the risk exposures involved in many securitization activities. Therefore, when evaluating capital adequacy, examiners should ensure that banking organizations that sell assets with recourse, that assume or mitigate credit risk through the use of credit derivatives, and that provide direct credit substitutes and liquidity facilities to securitization programs are accurately identifying and measuring these exposures-and maintaining capital at aggregate levels sufficient to support the associated credit, market, liquidity, reputational, operational, and legal risks. 

Examiners should also review the substance of securitization transactions when assessing underlying risk exposures. For example, partial, first-loss direct credit substitutes that provide credit protection to a securitization transaction can, in substance, involve the same credit risk as the risk involved in holding the entire asset pool on the institution's balance sheet. However, under current rules, regulatory capital is explicitly required only against the amount of the direct credit substitute, which can be significantly different from the amount of capital that the institution should maintain against the concentrated credit risk in the guarantee. Supervisors and examiners should ensure that banking organizations have implemented reasonable methods for allocating capital against the economic substance of credit exposures arising from early amortization events and liquidity facilities associated with securitized transactions. These facilities are usually structured as short-term commitments to avoid a risk-based capital requirement, even though the inherent credit risk may be approaching that of a guarantee.5 

If, in the supervisor's judgment, an institution's capital level is not sufficient to provide protection against potential losses from such credit exposures, this deficiency should be reflected in the banking organization's CAMELS or BOPEC ratings. Furthermore, supervisors and examiners should discuss the capital deficiency with the institution's management and, if necessary, its board of directors. The institution will be expected to develop and implement a plan for strengthening the organization's overall capital adequacy to levels deemed appropriate given all the risks to which it is exposed. 

Risk-Based Capital Provisions Affecting Asset Securitization 

The risk-based capital framework has three features that affect the asset securitization activities of banking organizations. First, the framework assigns risk weights to loans, ABS, and other assets related to securitization. Second, bank holding companies that transfer assets with recourse to the seller as part of the securitization process will now be explicitly required to hold capital against their off-balance-sheet credit exposures. However, the specific capital requirement will depend on the amount of recourse retained by the transferring institution and the type of asset sold with recourse. Third, banking organizations that provide credit enhancement to asset securitization issues through standby letters of credit or other means will have to hold capital against the related off-balance-sheet credit exposure. 

The risk weights assigned to an asset-backed security depend on the issuer and on whether the assets that comprise the collateral pool are mortgage-related assets. ABS issued by a trust or a single-purpose corporation and backed by non-mortgage assets are to be assigned a risk weight of 100 percent. 

Securities guaranteed by U.S. government agencies and those issued by U.S. government- sponsored agencies are assigned risk weights of 0 percent and 20 percent, respectively, because of the low degree of credit risk. Accordingly, mortgage pass-through securities guaranteed by GNMA are placed in the risk category of 0 percent. In addition, securities such as participation certificates and CMOs issued by FNMA or FHLMC are assigned a 20 percent risk weight. 

However, several types of securities issued by FNMA and FHLMC are excluded from the lower risk weight and slotted in the 100 percent risk category. Residual interests (for example, CMO residuals) and subordinated classes of pass-through securities or CMOs that absorb more than their pro rata share of loss are assigned to the 100 percent risk-weight category. Furthermore, high-risk mortgage derivative securities and all stripped, mortgage-backed securities, including IOs, POs, and similar instruments, are assigned to the 100 percent risk-weight category because of their high price volatility and market risk. The treatment of stripped mortgage-backed securities will be reconsidered when a method to measure interest-rate risk is incorporated into the risk-based capital guidelines. 

A privately issued mortgage-backed security that meets the criteria listed below is considered a direct or indirect holding of the underlying mortgage-related assets and is generally assigned to the same risk category as those assets (for example, U.S. government agency securities, U.S. government-sponsored agency securities, FHA- and VA-guaranteed mortgages, and conventional mortgages). However, under no circumstances will a privately issued mortgage-backed security be assigned to the 0 percent risk category. Therefore, private issues that are backed by GNMA securities will be assigned to the 20 percent risk category as opposed to the 0 percent category appropriate to the underlying GNMA securities. The criteria that a privately issued mortgage-backed security must meet to be assigned the same risk weight as the underlying assets are as follows: 

  The underlying assets are held by an independent trustee, and the trustee has a first priority, perfected security interest in the underlying assets on behalf of the holders of the security. 
  The holder of the security has an undivided pro rata ownership interest in the underlying mortgage assets, or the trust or single-purpose entity (or conduit) that issues the security has no liabilities unrelated to the issued securities. 
  The cash flow from the underlying assets of the security in all cases fully meets the cash-flow requirements of the security without undue reliance on any reinvestment income. 
  No material reinvestment risk is associated with any funds awaiting distribution to the holders of the security. 

Those privately issued mortgage-backed securities that do not meet the above criteria are to be assigned to the 100 percent risk category. 

If the underlying pool of mortgage-related assets is composed of more than one type of asset, then the entire class of mortgage-backed securities is assigned to the category appropriate to the highest risk-weighted asset in the asset pool. For example, if the security is backed by a pool consisting of U.S. government-sponsored agency securities (for example, FHLMC participation certificates) that qualify for a 20 percent risk weight and conventional mortgage loans that qualify for the 50 percent risk category, then the security would receive the 50 percent risk weight. 

As previously mentioned, bank holding companies report their activities in accordance with GAAP, which permits asset securitization transactions to be treated as sales when certain criteria are met, even when there is recourse to the seller. This is the same reporting treatment that banks apply to residential mortgages sold with recourse. Before risk-based capital, there was no explicit capital requirement for these off-balance-sheet exposures. However, bank holding companies and banks-for residential mortgages sold with recourse-are now explicitly required to hold capital against the off-balance-sheet credit exposure arising from the contingent liability associated with the recourse provisions. This exposure, generally the outstanding principal amount of the assets sold with recourse, is considered a direct credit substitute that is converted at 100 percent to an on-balance-sheet credit-equivalent amount for appropriate risk weighting. 

A banking organization that contractually limits its maximum recourse obligation to an amount less than the full effective risk-based capital requirement for the transferred assets is required to hold risk-based capital equal to the maximum amount of the recourse obligation. Thus, a banking organization's capital requirement on low-level-recourse transactions would not exceed the maximum contractual amount it could lose under the recourse obligation. This capital treatment applies to low-level-recourse transactions involving all types of assets, including commercial loans and residential mortgages. 

Another divergence from the general risk-based capital treatment for assets sold with recourse concerns small-business obligations. Qualifying institutions that transfer small-business obligations with recourse are required, for risk-based capital purposes, to maintain capital only against the amount of recourse retained, provided two conditions are met. First, the transactions must be treated as a sale under GAAP, and second, the transferring institutions must establish, pursuant to GAAP, a non-capital reserve sufficient to meet the reasonably estimated liability under their recourse arrangements. 

Banking organizations will be considered qualifying if, pursuant to the Board's prompt-corrective-action regulation (12 CFR 208.30), they are well capitalized or, by order of the Board, adequately capitalized. To qualify, an institution must be determined to be well capitalized or adequately capitalized without taking into account the preferential capital treatment for any previous transfers of small-business obligations with recourse. The total outstanding amount of recourse retained by a qualifying banking organization on transfers of small-business obligations receiving the preferential capital treatment cannot exceed 15 percent of the institution's total risk-based capital. 

Banking organizations that issue standby letters of credit as credit enhancements for ABS issues must hold capital against these contingent liabilities under the risk-based capital guidelines. According to the guidelines, financial standby letters of credit are direct credit substitutes, which are converted in their entirety to credit-equivalent amounts. The credit-equivalent amounts are then risk weighted according to the type of counterparty or, if relevant, to any guarantee or collateral. 

5. For further guidance on distinguishing, for risk-based capital purposes, whether a facility is a short-term commitment or a direct credit substitute, see SR-92-11, ''Asset-Backed Commercial Paper Programs.'' Essentially, facilities that provide liquidity, but which also provide credit protection to secondary-market investors, are to be treated as direct credit substitutes for purposes of risk-based capital. 

SOUND RISK-MANAGEMENT PRACTICES 

Examiners should verify that an institution incorporates the risks involved in its securitization activities into its overall risk-management process. The process should entail (1) inclusion of risk exposures in reports to the institution's senior management and board to ensure proper management oversight; (2) adoption of appropriate policies, procedures, and guidelines to manage the risks involved; (3) appropriate measurement and monitoring of risks; and (4) assurance of appropriate internal controls to verify the integrity of the management process with respect to these activities. The formality and sophistication of an institution's risk-management system should be commensurate with the nature and volume of its securitization activities. Institutions with significant activities in this area are expected to have more elaborate and formal approaches to manage the risk of their secondary-market credit activities. 

Board and Senior Management Oversight 

Both the board of directors and senior management are responsible for ensuring that they fully understand the degree to which the organization is exposed to the credit, market, liquidity, operational, legal, and reputational risks involved in the institution's securitization activities. They are also responsible for ensuring that the formality and sophistication of the techniques used to manage these risks are commensurate with the level of the organization's activities. The board should approve all significant policies relating to risk management of securitization activities and should ensure that risk exposures are fully incorporated in board reports and risk-management reviews. 

Policies and Procedures 

Senior management is responsible for ensuring that the risks arising from securitization activities are adequately managed on both a short-term and long-run basis. Management should ensure that there are adequate policies and procedures in place for incorporating the risk of these activities into the overall risk-management process of the institution. Policies should ensure that the economic substance of the risk exposures generated by these activities is fully recognized and appropriately managed. In addition, banking organizations involved in securitization activities should have appropriate policies, procedures, and controls for underwriting asset-backed securities; funding the possible return of revolving receivables (for example, credit card receivables and home equity lines); and establishing limits on exposures to individual institutions, types of collateral, and geographic and industrial concentrations. Policies should specify a consistently applied accounting methodology and valuation methods, including SFAS 140 residual-value assumptions and the procedures to change those assumptions. (SFAS 140 has superseded SFAS 125.) 

Risk Measurement and Monitoring 

An institution's management information and risk-measurement systems should fully incorporate the risks involved in its securitization activities. Banking organizations must be able to identify credit exposures from all securitization activities and to measure, quantify, and control those exposures on a fully consolidated basis. The economic substance of the credit exposures of securitization activities should be fully incorporated into the institution's efforts to quantify its credit risk, including efforts to establish more formal grading of credits to allow for statistical estimation of loss-probability distributions. Securitization activities should also be included in any aggregations of credit risk by borrower, industry, or economic sector. 

An institution's information systems should identify and segregate those credit exposures arising from the institution's loan sale and securitization activities. These exposures include the sold portions of participations and syndications; exposures arising from the extension of credit enhancement and liquidity facilities; the effects of an early-amortization event; and the investment in asset-backed securities. Management reports should provide the board and senior management with timely and sufficient information to monitor the institution's exposure limits and overall risk profile. 

Stress Testing 

The use of stress testing, including combinations of market events that could affect a banking organization's credit exposures and securitization activities, is another important element of risk management. Stress testing involves identifying possible events or changes in market behavior that could have unfavorable effects on the institution and then assessing the organization's ability to withstand them. Stress testing should consider not only the probability of adverse events, but also likely worst-case scenarios. Analysis should be on a consolidated basis and consider, for instance, the effect of higher than expected levels of delinquencies and defaults, as well as the consequences of early-amortization events with respect to credit card securities, that could raise concerns about the institution's capital adequacy and its liquidity and funding capabilities. Stress-test analyses should also include contingency plans for possible management actions in certain situations. 

Valuation of Retained Interests 

Retained interests from securitization activities, including interest-only strips receivable, arise when a banking organization keeps an interest in the assets sold to a securitization vehicle that, in turn, issues bonds to investors. The methods and models that banking organizations use to value retained interests, as well as the difficulties in managing exposure to these volatile assets, can raise supervisory concerns. SR-99-37 and its reference interagency guidance (included in the ''Selected Federal Reserve SR-Letters'' at the end of this section) address the risk management and valuation of retained interests arising from asset securitization activities. 

Appropriate valuation and modeling methodologies should be used in valuing retained interests. The carrying value of a retained interest should be fully documented, based on reasonable assumptions, and regularly analyzed for any impairment in value. When quoted market prices are not available, accounting rules allow fair value to be estimated. An estimate must be based on the ''best information available in the circumstances'' and supported by reasonable and current assumptions. If a best estimate of fair value is not practicable, the asset is to be recorded at zero in financial and regulatory reports. 

Internal Controls 

One of management's most important responsibilities is establishing and maintaining an effective system of internal controls. Among other things, internal controls should enforce the offi-cial lines of authority and the appropriate separation of duties in managing the institution's risks. These internal controls must be suitable for the type and level of risks at the institution, given the nature and scope of its activities. Moreover, internal controls should ensure that financial reporting is reliable (in published financial reports and regulatory reports), including the reporting of adequate allowances or liabilities for expected losses. 

The internal-controls and risk-management function should also ensure that appropriate management information systems (MIS) exist to monitor securitization activities. Reporting and documentation methods must support the initial valuation of retained interests and ongoing impairment analyses of these assets. Pool-performance information will help well-managed banking organizations ensure, on a qualitative basis, that a sufficient amount of economic capital is being held to cover the various risks inherent in securitization transactions. The absence of quality MIS will hinder management's ability to monitor specific pool performance and securitization activities. At a minimum, MIS reports should address the following: 

  Securitization summaries for each transaction. The summary should include relevant transaction terms such as collateral type, facility amount, maturity, credit-enhancement and subordination features, financial covenants (termination events and spread-account capture ''triggers''), right of repurchase, and counterparty exposures. Management should ensure that the summaries for each transaction are distributed to all personnel associated with securitization activities. 
  Performance reports by portfolio and specific product type. Performance factors include gross portfolio yield, default rates and loss severity, delinquencies, prepayments or payments, and excess spread amounts. The reports should reflect the performance of assets, both on an individual-pool basis and for total managed assets. These reports should segregate specific products and different marketing campaigns. 
  Vintage analysis for each pool using monthly data. Vintage analysis will help management understand historical performance trends and their implications for future default rates, prepayments, and delinquencies, and therefore retained interest values. Management can use these reports to compare historical performance trends with underwriting standards, including the use of a validated credit-scoring model, to ensure loan pricing is consistent with risk levels. Vintage analysis also helps in the comparison of deal performance at periodic intervals and validates retained-interest valuation assumptions. 
  Static-pool cash-collection analysis. A static-pool cash-collection analysis involves reviewing monthly cash receipts relative to the principal balance of the pool to determine the cash yield on the portfolio, comparing the cash yield to the accrual yield, and tracking monthly changes. Management should compare monthly the timing and amount of cash flows received from the trust with those projected as part of the SFAS 125 (now SFAS 140) retained-interest valuation analysis. Some master-trust structures allow excess cash flow to be shared between series or pools. For revolving-asset trusts with this master-trust structure, management should perform a cash-collection analysis for each master-trust structure. These analyses are essential in assessing the actual performance of the portfolio in terms of default and prepayment rates. If cash receipts are less than those assumed in the original valuation of the retained interest, this analysis will provide management and the board with an early warning of possible problems with collections or extension practices, and impairment of the retained interest. 
  Sensitivity analysis. A sensitivity analysis measures the effect of changes in default rates, prepayment or payment rates, and discount rates to assist management in establishing and validating the carrying value of the retained interest. Stress tests should be performed at least quarterly. Analyses should consider potential adverse trends and determine ''best,'' ''probable,'' and ''worst-case'' scenarios for each event. Other factors that need to be considered are the impact of increased defaults on collections staffing, the timing of cash flows, spread-account capture triggers, over-collateralization triggers, and early-amortization triggers. An increase in defaults can result in higher than expected costs and a delay in cash flows, thus decreasing the value of the retained interests. Management should periodically quantify and document the potential impact to both earnings and capital, and report the results to the board of directors. Management should incorporate this analysis into their overall interest-rate risk measurement system.6 
  Statement of covenant compliance. Ongoing compliance with deal-performance triggers as defined by the pooling and servicing agreements should be affirmed at least monthly. Performance triggers include early amortization, spread capture, changes to over-collateralization requirements, and events that would result in servicer removal. 

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