Statement of Franklin D. Dreyer, Senior Vice President, Supervision and Regulation and Loans, Federal Reserve Bank of Chicago.

Statement of Franklin D. Dreyer, Senior Vice President, Supervision and Regulation and Loans, Federal Reserve Bank of Chicago, before the Subcommittee on Policy Research and Insurance of the Committee on Banking, Finance and Urban Affairs, U.S. House of Representatives, July 31, 1991

I thank you for this opportunity to discuss asset securitization as it relates to financial institutions. As you are aware, securitization of assets is one of several innovations changing the nature and complexity of our financial system. As with other innovations, an understanding of the benefits and risks involved in securitization is necessary to evaluate properly the role that it is increasingly playing in our financial markets. Staff members at the Federal Reserve have been carefully reviewing securitization to ensure that this process will not pose undue risk for depository institutions and their holding companies.

THE NATURE OF SECURITIZATION

Securitization is a process that transforms illiquid assets into marketable securities. The process has come to be considered a normal activity for depository institutions as well as for mortgage banks-indeed, the securitization of loans into tradable securities and subsequent sale of these securities now serve as an important substitute for retaining loans and funding these with bank deposits. Securitization activities started in the 1970s. Fostered by certain government and government-related agencies, primarily to support the housing industry, mortgage-related assets were the first instruments to be securitized. Since then, the economics of the process has sustained its momentum as other types of assets have recently been securitized.

Asset securitization, in its simplest form, consists of aggregating loans or similar assets having relatively homogeneous characteristics into pools that are transferred to a trust or special, limited-purpose corporation. This entity then issues securities backed directly by the pooled assets, and the principal and interest payments of these underlying assets flow directly through to the holders of the securities. The holders of these securities are essentially in the same position as if they owned the underlying assets directly. The trust or corporation that issues the securities is typically established by the organization that generated and pooled the underlying assets.

Over time, more complex securitization structures have evolved. These structures, originally issued in the form of collateral mortgage obligations CMOS) and now issued as real estate mortgage investment conduits (REMICs), aggregate and then redirect the principal and interest cash flows coming from the underlying assets and assign payment priorities to different classes of investors. These more complex structures have been developed to provide some classes of investors with a security that has a more certain maturity or average life and thus a more predictable overall yield. However, by providing greater certainty to some investors, the maturity and overall yield to other classes of investors become less certain. The introduction of these features, while increasing the complexity of asset-backed structures, has enhanced their marketability to different types of investors by appealing to their differing investment objectives and risk preferences.

Regardless of the type of structure, almost all securitization programs involve the use of a servicer. The servicer is responsible for collecting interest and principal payments on the loans or other assets in the underlying pool and for transmitting these funds to a trustee, who, in turn, passes them on to investors. A servicer may be the originator of the pooled asset or another financial institution that has acquired the right to service the underlying assets on behalf of the investor for a fee.

Another aspect of securitization is credit enhancement. This procedure involves use of a guarantor to make sure that principal and interest payments will be received by investors on a timely basis, even if the servicer does not collect these payments from the underlying obligors. One form of credit enhancement is a recourse provision, or guarantee, that requires the originator to cover any losses up to an amount contractually agreed upon. Some asset-backed securities, such as those backed by credit card receivables, typically use a "spread account" as a credit enhancement. A spread account is actually an escrow account whose funds are derived from a portion of the spread between the interest earned on the assets in the underlying pool and the lower interest paid on securities issued by the trust.

Credit enhancement may also be provided through over-collateralization when the value of the underlying assets in the pool exceeds the face value of the securities issued against it. Senior-subordinated security structures also provide credit enhancement but generally benefit only the senior class. Other forms of credit enhancement include standby letters of credit or surety bonds from third parties. Asset-backed securities other than those securities supported by pools of mortgages generally depend on some form of credit enhancement provided by the originator or third party to insulate the investor from some or all of any credit losses. Issues of mortgage-backed securities can also be backed by the Government National Mortgage Association (GNMA), a government agency backed by the full faith and credit of the U.S. government, or by the Federal National Mortgage Association (FNMA) or the Federal Home Loan Mortgage Corporation (FHLMC), which are government-sponsored agencies.

THE SECURITIZATION MARKET

Asset securitization has grown substantially over the past few years. Residential mortgage-backed, pass-through securities are the largest segment of the asset-backed securities market. They have increased 290 percent since 1984 to nearly $1.1 trillion by the end of 1990. As of year-end 1990, approximately 40 percent of outstanding one- to four-family residential mortgage debt has been securitized. Furthermore, over the same period, securities backed by other types of assets, such as credit card receivables, automobile loans, student loans, and other types of consumer loans, have also been created. The annual issuance of securities backed by assets other than mortgages has increased from slightly more than $1 billion in 1985 to almost $43 billion by the end of 1990. As of year-end 1990, approximately 10 percent of consumer debt had been securitized.

Generally, the biggest purchasers of asset-backed securities have been banks, savings and loan associations, life insurance companies, and pension funds. Based on third-quarter 1990 data, commercial banks held approximately 19.1 percent of the total mortgage-related securities outstanding. Savings and loan associations held 14.5 percent, life insurance companies held 14.3 percent, pension funds held 7.3 percent, and mutual funds held 4.5 percent, with the remaining amount held by other investors.

From the beginning, banking organizations have been involved in the securitization process as originators and securitizors of residential mortgages. Over the past few years, they have ventured into securitization of other types of assets, such as credit card receivables and other types of consumer loans. Also, many banking organizations have increased their reliance on securitization for funding, have acted as servicers or trustees for securitized issues, and have increased their holdings of asset-backed securities. More recently, as noted above, banking organizations have begun to purchase asset-backed securities or derivative instruments for investment or hedging purposes.

Banking organizations have found securitization an attractive way to reduce interest rate risk, and securitization provides an additional source of funding, generally at a lower cost than other funding sources. Securitization helps reduce interest rate risk since the assets are removed from the selling institution's books. This risk is passed on to the investors, and, at the same time, the cash received in the asset sale raises funds for further lending activities. Furthermore, the fees earned by banking organizations as servicers or trustees of asset-backed securities have provided a source of noninterest income.

Banking organizations may also seek to securitize assets to accomplish several other objectives. First, in selling, rather than holding assets they have originated, banking organization are able to lower both their reported liabilities and assets, thereby reducing reserve and capital requirements and deposit insurance premiums. This occurs because traditional lending activities are generally funded by de posits or other liabilities, and both the asset and related liabilities are reflected on the balance sheet. Deposit liabilities must generally increase to fund additional loans :

In contrast, so long as there is no recourse back to the banking organization that originated the assets, the securitization process generally does not increase on-balance-sheet liabilities in proportion to the volume of loans or other assets generated. When banking organizations securitize their assets and these transactions are treated as sales-that is, there is no recourse back to the banking organization that originate the loans-both the assets and the related asset backed securities (that is, liabilities) are no reflected on the banking organization's balance sheet. The cash proceeds from the securitization transactions are generally used to originate or make additional loans for securitization, and the process is repeated. Thus, for the same volume of loan originations, securitization results in lower reported assets and liabilities when compared with traditional lending activities.

As noted above, banking organizations can earn fee income from servicing the loans that they originated and sold. Additional advantage include faster recognition of fee income than normal. Previously deferred loan fees related to assets that are sold, and any excess servicing fees created by the asset securitization process can, under generally accepted accounting principles (GAAP), be recognized at the time of sale rather than be amortized over the life of th asset as would be the case if it was held on the bank's books.

RISKS OF SECURITIZATION

While clear benefits accrue to banking organizations that engage in securitization activities as well as to those that invest in asset-backed securities, these activities have the potential of increasing the overall risk profile of the banking organization if they are not carried out in a prudent manner. For the most part, the risks that financial institutions encounter in the securitization process are identical to those that they face in traditional lending transactions. These involve credit risk, concentration risk, operational risk, liquidity risk, and interest rate risk, including prepayment risk. However, since the securitization process separates the traditional lending function into several limited roles, such as originator, servicer, credit enhancer, trustee, and investor, the types of risks that a banking organization may encounter will differ depending on the role it assumes.

As with direct investments in the underlying assets, investors in asset-backed securities will be exposed to credit risk, that is, the risk that obligors will default on principal and interest payments. Although investors in most asset-backed securities are largely shielded from credit risk because of government-related guarantees and other credit enhancements, investors are still subject to the risk that the various parties, for example, the servicer or credit enhancer, in the securitization structure will be unable to fulfill their contractual obligations. Moreover, investors may be susceptible to concentrations of risks across various asset-backed security issues through overexposure to an organization performing various roles in the securitization process or as a result of geographic concentrations within pools of assets.

Furthermore, since the secondary markets for certain asset-backed securities may be thin, investors may encounter greater-than-anticipated difficulties when seeking to sell their asset-backed securities. Additionally, investors are still subject to interest rate risk, which can vary greatly depending on the nature of the individual security they hold. Indeed, while certain security classes of a REMIC are structured so that investors are subject to substantially less interest rate risk than that associated with the underlying mortgages, other classes of the same REMIC are necessarily structured so that these investors are exposed to considerably greater interest rate risk. Banking organizations that provide credit enhancements to asset-backed security issues are, of course, subject to the credit risk inherent in the assets they are guaranteeing. In addition, as credit enhancer, a banking organization may be exposed to risk stemming from undue concentrations of assets coming from a limited geographical area or from an originator that may have allowed its own credit standards to deteriorate.

Also, to generate the higher volume of receivables necessary to maintain or expand a securitization program, a banking organization that originates the loans to be securitized may consciously or unconsciously lower its credit standards. Conversely, a banking organization that issues asset-backed securities may be subject to pressures to sell only their best assets, thus reducing the quality of their own loan portfolios.

Banking organizations that service the loans underlying asset-backed securities must ensure that their policies, operations, and systems will not permit breakdowns that may lead to defaults. The servicer, whether it be the originator of the assets or a third-party servicer, has a responsibility to perform, which includes having to undertake reasonable collection efforts to collect delinquent payments. In this regard, the collection costs that an anticipated volume of problem assets may require could substantially raise the overall costs of operations for the servicer and even exceed the related fee income. Furthermore, if a servicer fails to perform properly, the trustee may take away its right to continue to service assets and place those servicing rights with another servicer, which would, of course, collect the servicing fees.

Beyond the above operational risks, certain servicing contracts, such as those entered into with GNMA, FNMA, and FHLMC, increasingly contain recourse provisions that subject the servicer to direct credit risk. Issuers may face pressures to repurchase securities backed by loans or leases that they have originated but that have deteriorated and become nonperforming, thus providing "moral recourse" for the securities.

REGULATORY RESPONSE

In view of the increasing involvement of banking organizations in the asset securitization process and the desire to foster prudent banking practice with respect to this activity, the Federal Reserve and the other banking regulators have taken several steps over the years to address securitization activities. These steps include the following: (1) regulatory reporting requirements that, in general, permit banks to take assets they have originated and securitized off their balance sheets only when they have sold" those assets without recourse; (2) the issuance in 1988 of an interagency supervisory policy statement to address investments in stripped, asset-backed securities and residual interests and a subsequent proposed revision that will address "high risk" collateralized mortgage obligations; (3) development of examination guidelines addressing various aspects of the securitization process; and (4) development of the risk-based capital framework.

In April 1988, the three federal banking agencies issued a joint policy statement advising banking organizations on the selection of securities dealers and unsuitable investment practices. In addition, this policy also discussed several types of instruments, such as stripped mortgage-backed securities and residual interests in pools of securitized assets, with very volatile prices and high-risk characteristics due to extreme sensitivity to interest rate risk. The Board policy statement indicated that these investments may be unsuitable for most institutions. The three banking agencies, along with the Office of Thrift Supervision (OTS), are currently updating the 1988 policy statement to address other "high-risk" classes of CMOs and REMICs. The high-risk nature of these securities stems from the manner in which the embodied interest rate risk affects the cash flows to investors resulting in especially volatile price movements.

Examiner guidelines on asset securitization have been established for use by the Federal Reserve's examiners. These guidelines provide a structured framework for assessing the risks associated with the securitization process at banking organizations and for determining that banking organizations have implemented certain prudential policies and procedures in this area. In accordance with these guidelines, examiners are to determine the following:

* Securitization activities are integrated into the overall strategic objectives of the organization.

* Sources of credit risk are understood an properly analyzed and managed, without excessive reliance on credit ratings by outside agencies.

* Credit, operational, and other risks are recognized and are addressed through appropriate policies, procedures, management report and other controls.

* Possible sources of structural failure in securitization transactions are recognized, and the organization has adopted measures to minimize the impact of such failures should they occur.

* The organization is aware of the legal risks and uncertainty regarding various aspects of securitization.

* Concentrations of exposure in the underlying asset pools, in the asset-backed securities portfolio, or in the structural elements of securitization transactions are avoided.

* All sources of risk are evaluated at the inception of each securitization activity and are monitored on an ongoing basis.

Special seminars on asset securitization are conducted for senior Federal Reserve examiners, and securitization is a regular topic in the System's examiner schools. In-depth coverage of securitization issues will continue to be part of regular examiner training program.

Capital requirements play an important role in the supervision of banking organizations. As a general, long-standing rule, bank regulatory agencies have maintained a basic tenet that when there is risk associated with a financial arrangement, capital should be held against that risk. The risk-based capital framework assigns assets and off-balance-sheet items to various broad risk categories, depending on the level of credit risk associated with that asset.

The risk-based capital framework has three main features that will affect the asset securitization activities of banking organizations. First, the framework assigns risk weights to loan asset-backed securities, and other assets related to securitization. Second, bank holding companies that transfer assets with recourse to the seller as part of the securitization process are required under the risk-based capital guidelines to hold capital against their off-balancesheet credit exposures. Under GAAP, such transactions may be treated as sales that remove the assets sold with recourse from the bank holding company's books. Third, banking organizations that provide credit enhancement to asset securitization issues through standby letters of credit or by other means must hold capital against the related off-balance-sheet credit exposure.

The risk weights assigned to asset-backed securities that banking organizations hold as investments depend on the issuer and whether the assets that comprise the collateral pool are mortgage related assets. Asset-backed securities issued by a trust or by a single-purpose corporation and backed by nonmortgage assets are typically assigned a risk weight of 100 percent.

Mortgage-backed, pass-through securities guaranteed by GNMA are risk weighted at 0 percent because GNMA is explicitly backed by the full faith and credit of the United States. Mortgage securities, such as participation certificates and CMOs issued by FNMA or FHLMC, are risk weighted at 20 percent because they are government-sponsored agencies that carry only the implied backing of the United States.

However, several types of securities issued by FNMA and FHLMC, such as residual interests and CMO classes that absorb more than their share of loss, are excluded from the lower risk weight and slotted in the 100 percent risk-weight category because of their extreme price volatility.

A privately issued, mortgage-backed security that meets certain criteria is considered either a direct or indirect holding of the underlying mortgage-related assets and is assigned to the same risk category as those assets (for example, the assets may be 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-weight category.

NEW PRODUCT DEVELOPMENT

In the past few years, securitization of assets has become an increasingly complex activity. Product development in this field is being carried out at a very fast pace because of (1) computer models that assist in redirecting the cash flows from the underlying assets in a number of different directions, (2) investor demand for more specialized products to meet their individual needs, (3) the marketplace growth with respect to the number of originators and investors, and (4) the globalization of the asset-backed securities markets.

The increasing complexity makes it potentially more difficult to determine what the risk is and who has it. We expect banking organizations, when they participate in securitization in any capacity, to ensure that the activities are clearly and logically integrated into the overall strategic objectives of the organization. Appropriate policies, procedures, and controls should be established by a banking organization before participating in asset securitization. Controls should include well-developed management information systems. In addition, significant policies and procedures should be approved and reviewed periodically by the organization's Board of Directors.

SUMMARY

Securitization has resulted in several benefits for banking organizations. It improves funding and enhances liquidity for the banking system, particularly in the housing and consumer sectors. It has also brought new investors into the marketplace because of the diversity of the securities offered. Securitization of assets has also helped banks to fund their portfolios.

But there are also potential drawbacks and risks associated with asset securitization. The complexity of risks in this process, coupled with the increasing pace of innovation, could make it difficult for banking organizations to liquidate some types of securities. Moreover, increasingly complex recourse or guarantee arrangements can make it more difficult to monitor the risks associated with this activity. In addition, adverse risk selection can weaken the credit underpinnings of the securitization process. Bank regulators must continue to carefully monitor the securitization processes now under way.