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Asset securitization: a supervisory perspective.

Asset Securitization: A Supervisory Perspective In recent years the number of banks and bank holding companies (referred to here as banking organizations) that have issued securities backed by their assets and that have acquired asset-backed securities as investments has increased markedly. The reason for this increase is that securitization activities, if conducted in a prudent manner, can yield significant financial and operational benefits for banking organizations. At the same time, bank supervisors must carefully assess the effect of asset securitization activities on the financial condition, performance, and risk profiles of banking organizations.

This article examines asset securitization from a supervisory perspective. The first section describes the mechanics of the securitization process, the structures of asset-backed securities, and the involvement of banking organizations in this process. It also discusses the incentives for issuing and acquiring asset-backed securities.

The second section outlines the supervisory issues associated with ownership or issuance of asset-backed securities by banking organizations and the supervisory policies and procedures used by the Federal Reserve System in light of the growing involvement of banking organizations in asset securitization. It summarizes generally accepted accounting principles (GAAP) and bank regulatory reporting requirements as they pertain to sales treatment of asset securitization transactions. This section also examines the provisions of the risk-based capital guidelines that relate to the asset securitization process.

AN OVERVIEW OF ASSET SECURITIZATION

In its simplest form, asset securitization involves the selling of assets. The process first segregates generally illiquid assets into pools and transforms these pools into capital market instruments. The payment of principal and interest on these instruments depends on the cash flows from the assets in the pool that underlies the new securities. The new securities may differ from their underlying assets in terms of denominations, cash flows, and other features that make the securities more attractive to investors.

Asset securitization, as we know it, began when the federal government encouraged the securitization of residential mortgages. In 1970, the Government National Mortgage Association (GNMA) created the first publicly traded mortgage-backed security. Soon, the Federal National Mortgage Association (FNMA) and the Federal Home Loan Mortgage Corporation (FHLMC), both government-sponsored agencies, also developed mortgage-backed securities. The guarantees that these government or government-sponsored agencies provide, which assure investors of the payment of principal and interest, have greatly facilitated the securitization of mortgage assets.

Asset securitization has grown dramatically over the past few years. The outstanding amount of residential mortgage-backed, pass-through securities, which are the largest segment of the asset-backed securities market, has increased approximately 168 percent since year-end 1984 to $769 billion by year-end 1988 (table 1). In addition to rapid growth in residential mortgage-backed securities, recent years have witnessed an explosion in the issuance of securities backed by other assets: credit card receivables, automobile loans, boat loans, commercial real estate loans, home equity loans, student loans, nonperforming loans, and lease receivables. The annual issuance of securities backed by assets other than mortgages has increased from slightly more than $1 billion in 1985 to more than $16 billion by the end of 1988.

The Securitization Process

The asset securitization process begins, as depicted in the chart, with the segregation of loans or leases into pools that are relatively homogeneous with respect to type of credit, maturity, and interest rate risk. These pools of assets are then transferred to a trust or other entity known as an issuer because it issues the securities that are acquired by investors. These asset-backed securities may take the form of debt, certificates of beneficial ownership, or other instruments. The issuer is typically protected from bankruptcy by various structural and legal arrangements. A sponsor that provides the assets to be securitized owns or otherwise establishes the issuer.

Each issue of asset-backed securities has a servicer responsible for collecting interest and principal payments on the loans or leases in the underlying pool of assets and for transmitting these funds to investors (or a trustee representing them). A trustee monitors the activities of servicers to ensure that they properly fulfill their role.

A guarantor may also be involved to see that principal and interest payments will be received by investors on a timely basis, even if the servicer is unable to collect these payments from the obligors. Many issues of mortgage-backed securities are either guaranteed directly by GNMA, a government agency backed by the full faith and credit of the U.S. government, or by FNMA or FHLMC, government-sponsored agencies that are not backed by the full faith and credit of the U.S. government but are perceived by the credit markets to have its implicit support. Privately issued, mortgage-backed securities and other types of asset-backed securities 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. Usually, credit enhancement is provided for several multiples of the historical losses experienced on the particular asset backing the security.

One form of credit enhancement is the 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." This 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. The amounts that accumulate in the account are used to cover credit losses in the underlying asset pool up to several multiples of historical losses on the underlying assets.

Overcollateralization, another form of credit enhancement covering a predetermined amount of potential credit losses, occurs when the value of the underlying assets exceeds the face value of the securities. Also, the senior-subordinated security structure provides credit enhancement, generally to the senior class. Under such a structure, at least two classes of asset-backed securities are issued, with the senior class having a priority claim on the cash flows from the underlying pool of assets. Since the senior class has this priority claim, cash flows from the underlying pool of assets must first satisfy the requirements of the senior class. Only after these requirements have been met will the cash flows be directed to service the subordinated class. Therefore, the subordinated class must absorb credit losses before any are charged to the senior portion. Other forms of credit enhancement include standby letters of credit or surety bonds from third parties that protect investors against losses.

An investment banking firm or other organization generally serves as an underwriter for asset-backed securities. In addition, for asset-backed issues that are publicly offered, a credit rating agency will analyze the policies and operations of the originator and servicer, as well as the structure, underlying pool of assets, expected cash flows, and other attributes of such securities. Before assigning a rating to the issue, the rating agency will also assess the extent of loss protection provided to investors by any credit enhancements associated with the issue. (See the chart.)

Traditional lending activities are generally funded by deposits or other liabilities, and both the assets and related liabilities are reflected on the balance sheet. Deposit liabilities must generally increase to fund additional loans.

In contrast, the securitization process generally does not increase on-balance-sheet liabilities in proportion to the volume of loans or other assets being originated and securitized. As discussed more fully below, when banking organizations securitize their assets and these transactions are treated as sales, both the assets and the related asset-backed securities (that is, liabilities) are removed from the balance sheet. The cash proceeds from the securitization transactions are generally used to originate or acquire additional loans or other assets for securitization, and the process is then repeated. Thus, for the same volume of loan originations, securitization results in lower amounts of assets and liabilities when compared with traditional lending activities.

The Structure of

Asset-Backed Securities

Asset securitization involves different kinds of capital market instruments. These instruments may be structured as "pass-throughs" or "pay-throughs." Under a pass-through structure, the cash flows from the underlying pool of assets are passed through to investors on a pro rata basis. This type of security is typically a single-class instrument such as a GNMA pass-through. The pay-through structure, which has multiple classes, combines the cash flows from the underlying pool of assets and reallocates them to two or more issues of securities that have different cash flow characteristics and maturities. An example is the collateralized mortgage obligation (CMO), which has a series of bond classes, each with its own specified coupon and stated maturity. In most cases, the assets that make up the CMO collateral pools are pass-through securities backed by residential mortgages. Scheduled principal payments, and any prepayments, from the underlying collateral go first to the earliest maturing class of bonds. This first class of bonds must be retired before the principal cash flows are used to retire the later bond classes. The development of the pay-through structure was a result of the desire to broaden the marketability of these securities to investors who were interested in maturities other than those generally associated with pass-through securities.

Multiple-class, asset-backed securities may also be issued as derivative instruments such as "stripped" securities. Investors in each class of a stripped security will receive a different portion of the principal and interest cash flows from the underlying pool of assets. In their purest form, stripped securities may be issued as interest-only (IO) strips for which investors receive 100 percent of the interest from the underlying pool of assets and as principal-only (PO) strips for which the investors receive all of the principal.

In addition to these securities, other types of financial instruments may arise as a result of asset securitization. One such instrument is loan servicing rights that are created when organizations purchase the right to act as servicers for pools of loans. The cost of these purchased servicing rights may be recorded as an intangible asset when certain criteria are met. Excess servicing fee receivables, another financial instrument, generally arise when the cash flows from the underlying assets that a servicer expects to receive exceed standard normal servicing fees. Another instrument, asset-backed securities residuals (sometimes referred to as "residuals" or "residual interests"), represents claims on any cash flows that remain after all obligations to investors and any related expenses have been met. Such excess cash flows may result from overcollateralization or from reinvestment income. Residuals can be retained by sponsors or purchased by investors in the form of securities.

Involvement of

Banking Organizations

Banking organizations have long been involved in asset securitization, particularly in the well-developed market for securities backed by residential mortgages. More recently, banking organizations, besides substantially augmenting the volume of their activities in this area, have also started securitizing other types of assets, as mentioned earlier, particularly credit card receivables. Also, many banking organizations have increased their reliance on securitization for funding, have acted as servicers or trustees for securitized issues, and have purchased asset-backed securities or derivative instruments for investment or other purposes.

Currently, securities subsidiaries of bank holding companies may underwrite asset-backed securities originated by third parties as long as the criteria of the Federal Reserve Board's section 20 orders are met. (1) In June 1987, the Comptroller of the Currency (OCC) permitted national banks to underwrite securities backed by their own assets. This decision was challenged, and in December 1988, a federal district court ruled that such underwriting activities were in violation of the Glass-Steagall Act. The decision was recently reversed upon appeal by the OCC.

Banking organizations securities assets to accomplish several objectives. First, in selling rather than holding the originated assets, banking organizations are able to lower liabilities and assets and, therefore, reduce their reserve and capital requirements and deposit insurance premiums. Securitization also provides an additional source of funding, generally at a lower cost than other funding sources. At the same time, the organization can earn fee income from originating loans that are sold and by then servicing those loans.

Decisions to sell rather than hold loans that are used to back securities also affect the timing for recording fee revenue in the income statement. Once the sales are completed, banking organizations can immediately recognize income from (1) syndication fees, (2) previously deferred loan fees related to loans that are sold, and (3) any excess servicing fees created by the asset securitization process.

Thus, asset sales boost standard income measures, such as return on assets, in two ways. They serve to bolster income in the period of the sale through the generation of fees while reducing the total volume of assets and thus raising the return on assets ratio. By creating a process, or "pipeline," that continually originates and securitizes assets, thereby removing them from the balance sheet, a banking organization can use its systems and loan expertise to originate loans that otherwise might not be made. Thus, a banking organization can increase its share of markets for particular types of loans without the deterioration of its capital ratios.

The largest purchasers of asset-backed securities have been pension funds, insurance companies, savings and loan associations, and commercial banks. Investors tend to be risk averse. Thus, asset-backed securities are attractive investments because they are considered relatively safe as a result of the government or government-sponsored agencies' guarantees or because of private credit enhancements. Also, the returns on asset-backed securities are typically higher than those on U.S. Treasury securities with comparable maturities. Furthermore, investors are able to diversify their portfolio by acquiring different types of assets, for example, mortgages or credit card receivables, from different geographic areas.

SUPERVISORY CONSIDERATIONS, POLICIES,

AND PROCEDURES REGARDING

ASSET SECURITIZATION

While clear benefits accrue to banking organizations that engage in securitization activities and 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, funding 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 bank will 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. Investors are also subject to the risk that the various parties in the securitization process, for example, the servicer or trustee, 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 several roles in the securitization process or as a result of geographic concentrations within the pool of assets providing the cash flows for an individual issue. Since the secondary markets for certain asset-backed securities are thin, investors may also encounter greater-than-anticipated difficulties in selling their securities. Furthermore, certain derivative instruments, such as stripped, asset-backed securities and residuals, may be extremely sensitive to interest rates and volatile in price. Therefore, these instruments may dramatically affect the risk exposure of investors unless they are used in a properly structured hedging strategy.

Banking organizations that issue asset-backed securities may be subject to pressures to sell only their best assets--thus reducing the quality of their own loan portfolios. On the other hand, some banking organizations may feel pressures to relax their credit standards because they can sell assets with higher risk than those they normally would retain for their own portfolios.

Banking organizations that service securitization issues must ensure that their policies, operations, and systems will not permit breakdowns that may lead to defaults. Issuers and servicers may face pressures to provide "moral recourse" by repurchasing securities backed by loans or leases they have originated that have deteriorated and become nonperforming. Funding risk may also be a problem for issuers when market aberrations do not permit the timely issuance of asset-backed securities that are in the securitization pipeline.

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 include (1) maintenance of regulatory reporting requirements for sales treatment that discourage banks from retaining credit risk when securitizing their assets; (2) issuance of an interagency supervisory policy statement, which discusses investments in stripped, asset-backed securities and residual interests; (3) development of the risk-based capital framework; and (4) development of examination guidelines for various aspects of the securitization process.

Sales versus Financing Treatment

for Reporting Purposes

Asset securitization transactions are frequently structured to obtain certain accounting treatments, which, in turn, affect reported measures of profitability and capital adequacy. These measures are used extensively in analyses performed by supervisory agencies and by the public to assess the financial condition and performance of banking organizations.

In transferring assets into a pool to serve as collateral for asset-backed securities, 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. Sales treatment results in the removal of the assets from the banking organization's balance sheet, thus reducing total assets relative to earnings and capital, and thereby producing higher performance and capital ratios. Treatment of 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 are subject to reserve requirements. (2) From a supervisory standpoint, outright sales do not present a problem in that such transactions transfer all of the risks and rewards of ownership of the underlying assets. On the other hand, transfers that involve recourse to the selling institution, if treated as sales, can result in credit risk that is not reflected on the balance sheet of that institution.

For bank holding companies and their nonbank affiliates, or for any other nonbank entity publishing audited financial statements, these accounting treatments are determined by GAAP. Bank holding companies also follow GAAP when preparing regulatory reports filed with the Federal Reserve. Insured commercial banks, on the other hand, must report asset securitization transactions in accordance with regulatory reporting requirements set forth in the instructions for the commercial bank Reports of Condition and Income (Call Reports). The federal banking agencies jointly determine these reporting requirements, which are published by the Federal Financial Institutions Examination Council (FFIEC). While these regulatory reporting requirements usually follow GAAP, special reporting requirements apply to sales of assets, including those involved in asset securitization. When asset transfers do not involve recourse to the selling institution, then both GAAP and regulatory reporting requirements are consistent.

Sales Treatment

for Financial Reporting Purposes

Under GAAP, an asset sale occurs when both the risks and rewards of ownership have been transferred to the purchaser. Thus, asset transfers for securitization that do not involve direct or indirect recourse to the transferring banking organization are treated as sales. When asset transfers involve recourse, on the other hand, sales or financing treatment is determined by the criteria specified by Financial Accounting Standards Board Statement No. 77 (FASB 77). (3)

FASB 77 defines recourse as the right of a transferee of assets to receive payment from the transferor for the "failure of the debtors to pay when due, effects of prepayments, or adjustments resulting from defects in the eligibility of the transferred receivables." This standard establishes the following criteria that, is satisfied, permit a transfer of receivables with recourse to be considered a sale of the assets rather than a financing transaction:

1. The transferor surrenders control of the future economic benefits relating to the receivables.

2. The transferor can reasonably estimate its obligation under the recourse provisions.

3. The transferee cannot return the receivables to the transferor except pursuant to the recourse provisions.

When the transfer of assets is deemed a sale in accordance with these criteria, the assets that have been sold are removed from the transferor's balance sheet.

At the same time, the amount of losses estimated to accrue to the seller under the recourse provisions must be recorded as a direct liability on the seller's books. This balance sheet liability (the recourse liability account) must be periodically adjusted to reflect any changes in such loss estimates. The sales gain or loss is the difference between the sales price, adjusted for this accrual of estimated losses, and the recorded amount of net receivables (gross receivables, including any fees or charges owed by the debtors included

therein, less the unearned portion of these fees and charges). (4)

Sales Treatment for Call Report Purposes

The Call Report instructions for commercial banks contain a general rule that applies to all "sales of assets," other than participations in pools of residential mortgages. This instruction provides that a transfer of loans or other assets is reported as a sale "only if the transferring institution (1) retains no risk of loss from the assets transferred resulting from any cause and (2) has no obligation to any party for the payment of principal or interest on the assets transferred resulting from any cause." A transfer involving any retention of risk or obligation for payment, even if limited under the terms of the transfer agreement, is generally considered a borrowing transaction, and the entire amount of the assets transferred must remain on the books of the transferring institution. This risk retention may occur directly as a result of recourse provisions or, indirectly, as a result of retaining a subordinated class of an asset-backed security or by some other means. Thus, securitization transactions involving recourse to the originator will generally be reported as financings for Call Report purposes.

As an exception to the general rule, under the separate Call Report instruction for "participation in pools of residential mortgages," banks engaging in the disposal of residential mortgage loan pools under the programs of GNMA, FNMA, and FHLMC are able to treat such transactions as sales of the underlying mortgages without regard to the amount of risk retained by the seller.

Banks that sell "private" certificates of participation in pools of residential mortgages, (that is, pools that are not sold through a government agency program) are permitted to treat such transactions as sales only when the selling "bank does not retain any significant risk of loss, either directly or indirectly." Recourse is deemed significant when the maximum contractual exposure under the recourse provision (or through retention of a subordinate interest in the mortgages) at the time of the transfer is greater than the amount of the probable loss that the bank has reasonably estimated for the transferred mortgages. Under such circumstances, the issuing bank has retained the entire risk of loss, and the transfer of mortgages must be reported as a financing transaction.

The special reporting requirements for transfers involving residential mortgages were implemented so as not to hamper the development of the secondary mortgage markets. When these reporting requirements were adopted, sales of residential mortgages entailed little or no risk retention by the selling institution. The FFIEC is now reviewing the general regulatory reporting treatment of asset sales with recourse. In connection with this review, the FFIEC is evaluating the need for the special reporting requirements for residential mortgage sales and the appropriate way to apply capital requirements to transfers of residential mortgages with recourse. The FASB is also reviewing GAAP accounting standards for asset sales with recourse in conjunction with its Financial Instruments Project and expects to develop a comprehensive set of accounting standards for all financial instruments, including those associated with asset securitization.

Regarding the rationale for the regulatory reporting requirements for asset sales with recourse, the banking regulators historically have considered the existence of any risk that may be borne by the seller as the determining factor in deciding if sales treatment is appropriate. Also, regulators have traditionally been concerned that loss estimation may be virtually impossible for certain types of loans, such as commercial loans, construction loans, and loans to developing countries. Such estimates, however, may be possible for pools of residential mortgages or consumer loans. Under GAAP, sales treatment is prohibited when losses on the transferred loans cannot be estimated.

In some asset transfers, the transferor, generally the originator, may be subject to a partial or limited recourse provision. Even when the terms of the transfer ostensibly provide only limited recourse, it may, in fact, comprise all losses that are likely to occur. Thus the potential losses to the bank are the same as they would have been if the assets had not been sold. For example, in the transfer of a group of high quality assets with a "reasonably estimated" loss rate of 1 percent, if the transferor assumes the risk of default up to a maximum of 10 percent of the total dollar value of the assets transferred, the transferor in effect retains the entire risk inherent in the assets transferred. In addition, to remain viable in the market, the transferor may feel moral pressure to insulate investors from any losses above the amount it is legally committed to meet.

Finally, when "sales" can only be made with recourse, as opposed to selling assets at enough of a discount to insulate the purchaser of the assets from all but catastrophic losses, banks may tend to sell only the highest quality assets and keep those of lower quality.

As the asset securitization process has evolved, the banking agencies have reviewed proposed types of asset securitization transactions for compliance with the rules for reporting sales of assets on the Call Report. One such transaction approved by the banking agencies did not involve recourse to the selling bank but instead used a separate spread account, funded through excess cash flows from the underlying pool of assets, to absorb credit losses on the transferred loans. The Federal Reserve and the other banking agencies determined that, for regulatory reporting purposes, sales treatment is appropriate for such structures because the selling bank does not retain the risk of loss.

Interagency Investment Policy Statement

On April 20, 1988, the Federal Reserve, along with the other federal banking agencies, issued a policy statement that addressed investment and trading practices of insured commercial banks. This policy statement also covered stripped, mortgage-backed securities and residual interests. Supervisory concerns about these instruments arise because of their extreme sensitivity to interest rates and the resulting price volatility. Generally, POs increase in value when interest rates decline because prepayments of mortgages increase, thus shortening their maturities and allowing investors to recover their investment sooner than they anticipated. In contrast, IOs and residuals increase in value when interest rates rise because prepayments decline, maturities lengthen, and more interest is collected on the underlying mortgages. Therefore, banking organizations sometimes use the purchase of a PO to offset the effect of interest rate movements on the value of mortgage servicing, and the purchase of an IO or residual to offset interest rate risk associated with mortgages and similar instruments.

However, when purchasing an IO, PO, or residual, without offsetting hedges, the investor may be speculating on future interest rate movements and how these movements will affect the prepayments of the underlying collateral. Furthermore, stripped, mortgage-backed securities that do not have the guarantee of a government agency or government-sponsored agency as to principal and interest have an added element of credit risk. The interagency policy statement on such investments discussed the appropriateness of them for banks and the prudential measures that a bank should take to protect itself from undue risk when it invests in these instruments. (5)

Under guidelines set forth in the policy statement, IOs and POs may be unsuitable for an institution's investment portfolio, particularly if held in significant amounts. Generally, these guidelines state that banks should not invest in stripped, mortgage-backed securities, such as IOs and POs, unless they have highly sophisticated and well-managed securities portfolios, mortgage portfolios, or mortgage banking functions. In such institutions, however, the acquisition of IOs and POs should only be undertaken in conformance with carefully developed and documented plans prescribing specific positioning limits and control arrangements that have been approved by the bank's board of directors.

Risk-Based Capital Provisions Affecting

Asset Securitization

Capital requirements play an important role in the supervision of banking organizations. The new risk-based capital framework, published in January 1989, assigns assets and the credit equivalent amounts of off-balance-sheet items to various broad risk categories, depending on the level of credit risk associated with that asset. The aggregate dollar value of the amount in each risk category is then multiplied by the risk weight associated with it. The resulting weighted values from each of the risk categories are added together, and this sum is the bank's total of risk-weighted assets. An organization's capital (composed of stockholders' equity and certain other items) is then divided by its total of risk-weighted assets to calculate its capital ratio. (6) The risk-based capital framework will be phased in beginning at the end of 1990 and will be fully effective in 1993.

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 loans, 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 will now explicitly be required to hold capital against their off-balance-sheet credit exposures. Third, banking organizations that provide credit enhancement to asset securitization issues through standby letters of credit or by other means will have to hold capital against the related off-balance-sheet credit exposures.

The risk weights assigned to an asset-backed security depend on the issuer and whether the assets that constitute the collateral pool are mortgage related, for example, residential mortgages or pass-through securities. Asset-backed securities issued by a trust or by a single-purpose corporation and backed by nonmortgage assets will receive 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 and 20 percent respectively because of the low degree of credit risk. Accordingly, mortgage-backed, pass-through securities guaranteed by GNMA will have a risk weight of 0 percent. In addition, securities such as participation certificates and CMOs issued by FNMA or FHLMC will have a ris weight of 20 percent.

However, several types of securities issued by FNMA and FHLMC are excluded from the lower risk weight and slotted in the 100 percent risk weight 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, all stripped, mortgage-backed securities, including IOs, POs, and similar instruments will also receive a risk weight of 100 percent because of their extreme price volatility. 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 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, 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. Therefore, private issues that are backed by GNMA securities will be assigned to the 20 percent risk-weight 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:

1. 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.

2. 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.

3. The cash flow from the underlying assets in all cases fully meets the cash flow requirements of the security without undue reliance on any reinvestment income.

4. 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 will receive a risk weight of 100 percent (table 2).

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 of the asset with the highest risk weight in the pool. 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 risk weight of 20 percent and conventional mortgage loans that qualify for a risk weight of 50 percent, 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. With the advent of the risk-based capital guidelines, bank holding companies will be explicitly required to hold capital against the off-balance-sheet credit exposure arising from the contingent liability associated with the recourse provisions. This exposure is considered a direct credit substitute that would be converted at 100 percent to an on-balance-sheet credit equivalent amount for appropriate risk weighting.

Banking organizations that issue standby letters of credit as credit enhancements for asset-backed security 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.

Examination Guidelines

for Asset Securitization (7)

The Federal Reserve is also in the process of developing and implementing guidelines to assist examiners in the on-site review of the involvement of banking organizations in securitization, both as participants and as investors. The guidelines provide a more structured framework for assessing the risks associated with the securitization process at banking organizations and for determining that they have implemented certain prudential policies and procedures in this area. In accordance with these guidelines, examiners are to determine that the following conditions are being satisfied:

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

* Sources of credit risk are understood, and 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 reports, and other controls.

* Liquidity and market risks are recognized, and the organization is not excessively dependent on securitization as a substitute for funding or as a source of income.

* Steps have been taken to minimize the potential for conflicts of interest due to securitization.

* Possible sources of structural failure in securitization transactions are recognized, and the organization has adopted measures to minimize the effect 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.

Moreover, special seminars on asset securitization have been conducted for senior examiners, and in depth coverage of securitization issues will continue to be part of a regular examiner training program.

CONCLUSION

In recent years the complexity of asset securitization has increased, and this trend most likely will continue. In addition, securitization is increasing in other countries, and international markets for asset-backed securities are expected to grow rapidly.

Asset securitization activities should remain beneficial to banking organizations when conducted in a prudent manner. Banking organizations, however, must carefully evaluate the risks inherent in new forms of asset securitization and maintain appropriate controls, systems, and other measures to minimize these risks. The Federal Reserve Board will continue to review new asset-backed security structures as they develop to assess the associated risks to banking organizations and the financial system and to factor these developments into its supervisory process.

(1) In April and May 1987, the Board approved applications to underwrite and deal in, to a limited extent, one- to four-family mortgage-related securities that are rated as investment quality (that is, one of the top four categories) by a nationally recognized rating agency. The Board found that these proposals, as limited in the Order, are consistent with section 20 of the Glass-Steagall Act. In addition, the Board approved applications, in July 1987, to underwrite and deal in, on a limited basis, consumer-receivable-related securities.

(2) Note, however, that the Federal Reserve's Regulation D (Reserve Requirements of Depository Institutions) defines what constitutes a reservable liability of a depository institution. Thus, although a given transaction may qualify as an asset sale for Call Report purposes, it nevertheless could result in a reservable liability under Regulation D.

(3) FASB 77, "Reporting by Transferors fro Transfers of Receivables with Recourse," was issued in December 1983.

(4) Similar but stricter rules applying to CMOs are presented in FASB Technical Bulletin 85-2, "Collateralized Mortgage Obligations."

(5) Press release, "Supervisory Policy Concerning Selection of Securities Dealers and Unsuitable Investment Practices," Federal Reserve Board, April 20, 1988.

(6) The amounts used for this calculation are taken from a banking organization's regulatory reports: the Call Report for commercial banks and the Consolidated Financial Statements for Bank Holding Companies (F.R Y-9C).

(7) The Federal Reserve's examination guidelines were developed by the Asset Securitization Task Force headed by Franklin D. Dreyer, Senior Vice President, Federal Reserve Bank of Chicago. The other members of the task force, from the Reserve Banks, are James Barnes, Lawrence Cuy, George Gregorash, Barbara Kavanagh, Mark Levonian, and Donald Wilson, and from the Board, Roger Cole and the authors.
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Author:Edwards, Gerald A., Jr.
Publication:Federal Reserve Bulletin
Date:Oct 1, 1989
Words:6437
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