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Trading and Capital-Markets Activities Manual

Instrument Profiles: Collateralized Loan Obligations  (Continued)
Source: Federal Reserve System 
(The complete Activities Manual (pdf format) can be downloaded from the Federal Reserve's web site)

DESCRIPTION OF MARKETPLACE 

The primary buyers for CLO securities have been insurance companies and pension funds seeking attractive returns with high credit quality. To date, banking organizations typically have not been not active buyers of these securities. The secondary market is less fully developed and less active than the market for more traditional types of asset-backed securities. However, as the market grows and expands globally to spread-seeking investors, CLO securities are becoming more liquid. 

Market transparency can be less than perfect, especially when banks and other issuers retain most of the economic risk despite the securitization transaction. In addition, the early amortization features of some CLO transactions may not be fully understood by potential buyers. 

PRICING 

Securities issued in CLOs and synthetic securitizations carry coupons that can be fixed (generally yielding between 50 and 300 basis points over the Treasury curve) or floating (for example, 15 basis points over one-month LIBOR). Pricing is typically designed to reflect the coupon characteristics of the loans being securitized. The spread will vary depending on the credit quality of the underlying collateral, degree and nature of the credit enhancement, and degree of variability in the cash flows emanating from the securitized loans. 

HEDGING 

CLO issuers often use a variety of hedging instruments, including interest-rate swaps, currency swaps, and other derivatives, to hedge against various types of risk. For example, if the underlying assets are not denominated in U.S. dollars, currency risk may be hedged with swaps, caps, or other hedging mechanisms. Convertibility risk is considered for certain currencies in which the sovereign may be likely to impose currency restrictions. In such cases, certain currencies may not be permitted in the collateral pool regardless of the hedging mechanisms in place. Hedging instruments may also be used to address cash-flow mismatches between the payment characteristics of the CLO debt obligations and the underlying loans, such as differences in frequency of payments, payment dates, interest-rate indexes (basis risk), and interest-rate reset risk. 

RISKS 

Credit risk in CLOs and synthetic securitizations arises from (1) losses due to defaults by the borrowers in the underlying collateral and (2) the issuer's or servicer's failure to perform. These two elements can blur together, for example, a servicer who does not provide adequate credit-review scrutiny of the serviced portfolio, leading to a higher incidence of defaults. CLOs and synthetic securitizations are rated by major ratings agencies. 

Market risk arises from the cash-flow characteristics of the security. The greatest variability in cash flows comes from credit performance, including the presence of wind-down or acceleration features designed to protect the investor in the event that credit losses in the portfolio rise well above expected levels. For certain dynamic CLO structures that allow for active management, adequate disclosure should be made regarding a manager's ability to sell assets that may have appreciated or depreciated in value. This trading flexibility represents an additional level of risk to investors because an investor is exposed to the collateral manager's decisions. As a result, there may be a greater risk in CLOs (versus, for example, credit card securitizations) that its rating can change over time as the composition of the asset pool deteriorates. 

Interest-rate risk arises for the issuer from the relationship between the pricing terms on the underlying loans and the terms of the rate paid to note-holders, as well as from the need to mark to market the excess servicing or spread-account proceeds carried on the balance sheet. For the holder of the security, interest-rate risk depends on the expected life or repricing of the security, with relatively minor risk arising from embedded options. The notable exception is the valuation of the wind-down option. 

Liquidity risk can arise from credit deterioration in the asset pool when early amortization provisions are triggered. In that situation, the seller's interest is effectively subordinated to the interests of the other investors by the payment-allocation formula applied during early amortization. Other investors effectively get paid first, and the seller's interest will therefore absorb a disproportionate share of losses. Also, closure of the securitization conduit can create liquidity problems for the seller because the seller must then fund a steady stream of new receivables. When a conduit becomes unavailable due to early amortization, the seller must either find another buyer for the receivables or have receivables accumulate on its balance sheet, creating the need for another source of funding. In addition, these factors can create an incentive for the seller to provide implicit recourse- credit enhancement above and beyond any pre-existing contractual obligation-to prevent early amortization. Although incentives to provide implicit recourse are present in other types of securitizations to some extent, the early amortization feature of CLOs creates additional and more direct financial incentives to prevent its occurrence because of concerns about damage to the seller's reputation if one of its securitizations performs poorly. 

Operational risk arises through the potential for misrepresentation of loan quality or terms by the originating institution, misrepresentation of the nature and current value of the assets by the servicer, and inadequate controls over disbursements and receipts by the servicer. 

ACCOUNTING TREATMENT 

Holder 

The accounting treatment for investments in CLOs and synthetic securitizations is determined by the Financial Accounting Standards Board's Statement of Financial Accounting Standards (SFAS) No. 115, ''Accounting for Certain Investments in Debt and Equity Securities,'' as amended by SFAS 125, ''Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities.'' SFAS 125 has been replaced by SFAS 140, which has the same title. See section 2120.1, ''Accounting,'' for further discussion. 

Seller 

SFAS 140 covers the accounting treatment for the securitization of receivables. These standards address (1) when a transaction qualifies as a sale for accounting purposes and (2) the treatment of excess spread and servicing assets arising from a securitization transaction when a sale is deemed to have occurred. 

RISK-BASED CAPITAL WEIGHTING 

The current capital treatment for the standard master-trust CLO described in this section has three components. First, banks use the low-level-recourse rule when calculating capital charges against any first-loss exposures they retain. Thus, the most junior tranche would carry a dollar-for-dollar capital charge up to 8 percent of the investor interest. Second, banks receive transferor certificates for their investments in the trust through the transferor's interest. As this represents the bank's proportional share in a larger pool of assets, 8 percent capital is held against the transferor's interest. Finally, the loan facilities which the bank has assigned or participated into the trust typically are not fully drawn. The bank maintains capital for its commitment to lend up to the limit of these facilities. If the transferring bank that sponsors the CLO retains a subordinated tranche that would provide credit protection, then the low-level-recourse rule would apply, that is, dollar-for-dollar capital generally would be assessed on the retained risk exposure. This is also true if an interest only receivable representing the future spread is booked as a receivable on the transferring bank's balance sheet. If the sale of assets is accounted for, in part or in its entirety, as a servicing asset under SFAS 125, then the capital charge takes the form of a tier 1 capital limitation. The current capital treatment limits the total amount of mortgage- and non-mortgage-servicing assets that can be included in tier 1 capital to no more than 100 percent. It further limits the amount of non-mortgage-servicing assets that can be included in tier 1 capital to no more than 25 percent. 

Examiners should evaluate whether the transferor's interest is of lower credit quality than the investors' interest and, if so, determine whether the 8 percent capital charge against the on-balance-sheet amount is sufficient given the issuing institution's risk exposure. If examiners determine that the transferor's interest is effectively subordinated to the investors' interest and thus provides credit protection to the issued securities, then the low-level-recourse treatment may be appropriate. SR-96-17, ''Supervisory Guidance for Credit Derivatives,'' provides some guidance for the capital treatment of synthetic securitizations. 

Synthetic CLOs can raise questions about the appropriate capital treatment when calculating the risk-based and leverage capital ratios. Capital treatments for three synthetic transactions follow. 

Transaction 1-Entire Notional Amount of Reference Portfolio Is Hedged 

In the first type of synthetic securitization, the sponsoring banking organization, through a synthetic CLO, hedges the entire notional amount of a reference asset portfolio. A special-purpose vehicle (SPV) acquires the credit risk on a reference portfolio by purchasing credit-linked notes (CLNs) issued by the sponsoring banking organization. The SPV funds the purchase of the CLNs by issuing a series of notes in several tranches to third-party investors. The investor notes are in effect collateralized by the CLNs. Each CLN represents one obligor and the banking organization's credit-risk exposure to that obligor, which could take the form of bonds, commitments, loans, and counterparty exposures. Since the note-holders are exposed to the full amount of credit risk associated with the individual reference obligors, all of the credit risk of the reference portfolio is shifted from the sponsoring banking organization to the capital markets. The dollar amount of notes issued to investors equals the notional amount of the reference portfolio. In the example shown in figure 1, this amount is $1.5 billion. 

If the obligor linked to a CLN in the SPV defaults, the sponsoring banking organization will call the individual CLN and redeem it based on the repayment terms specified in the note agreement. The term of each CLN is set so that the credit exposure (to which it is linked) matures before the maturity of the CLN, which ensures that the CLN will be in place for the full term of the exposure to which it is linked. 

An investor in the notes issued by the SPV is exposed to the risk of default of the underlying reference assets, as well as to the risk that the sponsoring banking organization will not repay principal at the maturity of the notes. Because of the linkage between the credit quality of the sponsoring banking organization and the issued notes, a downgrade of the sponsor's credit rating most likely will result in the notes also being downgraded. Thus, a banking organization investing in this type of synthetic CLO should assign the notes to the higher of the risk 

Figure 1-Transaction 1 

categories appropriate to the underlying reference assets or the issuing entity. 

For purposes of risk-based capital, the sponsoring banking organizations may treat the cash proceeds from the sale of CLNs that provide protection against underlying reference assets as cash collateralizing these assets.6 This treatment would permit the reference assets, if carried on the sponsoring banking organization's books, to be assigned to the zero percent risk category to the extent that their notional amount is fully collateralized by cash. This treatment may be applied even if the cash collateral is transferred directly into the general operating funds of the banking organization and is not deposited in a segregated account. The synthetic CLO would not confer any benefits to the sponsoring banking organization for purposes of calculating its tier 1 leverage ratio, however, because the reference assets remain on the organization's balance sheet. 

Continue to TRANSACTION 2-High-Quality, Senior Risk Position in Reference Portfolio Is Retained

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