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l l★K
Federal Reserve Bank
of Dallas
DALLAS, TEXAS
75265-5906
December 31, 1999
Notice 99-109
TO: The Chief Executive Officer of each
financial institution and others concerned
in the Eleventh Federal Reserve District
SUBJECT
Guidance on Asset Securitization Activities
DETAILS
The four federal banking agencies have issued a joint statement addressing their
supervisory approach to asset securitization activities. The statement reminds financial institution
management and examiners of fundamental risk management practices that should be in place at
institutions that engage in securitization activities. It highlights the risks associated with retained
interests in securitization activities. The statement also details current supervisory concerns about
the valuation and reporting of these assets and concentrations of these assets relative to capital.
Given the risks presented by these activities, the bank regulatory agencies are actively
considering the establishment of regulatory restrictions that would limit or eliminate the amount
of certain retained interests that may be recognized in determining the adequacy of regulatory
capital.
Reported values for retained interests should be reasonable, conservative and supported by objective and verifiable documentation. Institutions should ensure that sufficient
capital is held to support the risks associated with securitization activities and are expected to
place concentration limits on retained interests relative to equity capital. The statement reiterates
that institutions should establish and implement an adequate and independent audit function to
effectively oversee securitization activities.
The statement has been issued as part of the agencies’ ongoing review of securitization activities at insured depository institutions. The agencies continue to review banking institutions’ valuation of retained interests and the concentrations of these assets relative to capital. As
For additional copies, bankers and others are encouraged to use one of the following toll-free numbers in contacting the Federal
Reserve Bank of Dallas: Dallas Office (800) 333-4460; El Paso Branch Intrastate (800) 592-1631, Interstate (800) 351-1012;
Houston Branch Intrastate (800) 392-4162, Interstate (800) 221-0363; San Antonio Branch Intrastate (800) 292-5810.
-2-
applicable, the agencies will provide further guidance on the liquidity risk associated with overreliance on asset securitization as a funding source and on implicit recourse obligations.
ATTACHMENT
A copy of the agencies’ statement is attached.
MORE INFORMATION
For more information, please contact Dorsey Davis, (214) 922-6051, in the Banking
Supervision Department. For additional copies of this Bank’s notice, contact the Public Affairs
Department at (214) 922-5254.
Office of the Comptroller of the Currency
Federal Deposit Insurance Corporation
Board of Governors of the Federal Reserve System
Office of Thrift Supervision
INTERAGENCY GUIDANCE ON ASSET SECURITIZATION ACTIVITIES
BACKGROUND AND PURPOSE
Recent examinations have disclosed significant weaknesses in the asset securitization practices
of some insured depository institutions. These weaknesses raise concerns about the general level
of understanding and controls among institutions that engage in such activities. The most
frequently encountered problems stem from: (1) the failure to recognize and hold sufficient
capital against explicit and implicit recourse obligations that frequently accompany
securitizations, (2) the excessive or inadequately supported valuation of “retained interests,”1 (3)
the liquidity risk associated with over reliance on asset securitization as a funding source, and (4)
the absence of adequate independent risk management and audit functions.
The Office of the Comptroller of the Currency, the Federal Deposit Insurance Corporation, the
Board of Governors of the Federal Reserve System, and the Office of Thrift Supervision,
hereafter referred to as “the Agencies,” are jointly issuing this statement to remind financial
institution managers and examiners of the importance of fundamental risk management practices
governing asset securitization activities. This guidance supplements existing policy statements
and examination procedures issued by the Agencies and emphasizes the specific expectation that
any securitization-related retained interest claimed by a financial institution will be supported by
documentation of the interest’s fair value, utilizing reasonable, conservative valuation
assumptions that can be objectively verified. Retained interests that lack such objectively
verifiable support or that fail to meet the supervisory standards set forth in this document will be
classified as loss and disallowed as assets of the institution for regulatory capital purposes.
The Agencies are reviewing institutions' valuation of retained interests and the concentration of
these assets relative to capital. Consistent with existing supervisory authority, the Agencies may,
on a case-by-case basis, require institutions that have high concentrations of these assets relative
to their capital, or are otherwise at risk from impairment of these assets, to hold additional capital
commensurate with their risk exposures. Furthermore, given the risks presented by these
1
In securitizations, a seller typically retains one or more interests in the assets sold. Retained interests represent
the right to cash flows and other assets not used to extinguish bondholder obligations and pay credit losses, servicing
fees and other trust related fees. For the purposes of this statement, retained interests include over-collateralization,
spread accounts, cash collateral accounts, and interest only strips (IO strips). Although servicing assets and
liabilities also represent a retained interest of the seller, they are currently determined based on different criteria and
have different accounting and risk-based capital requirements. See applicable comments in Statement of Financial
Accounting Standard No. 125, "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of
Liabilities" (FAS 125), for additional information about these interests and associated accounting requirements.
Date:
December 13, 1999
Page 1
activities, the Agencies are actively considering the establishment of regulatory restrictions that
would limit or eliminate the amount of certain retained interests that may be recognized in
determining the adequacy of regulatory capital. An excessive dependence on securitizations for
day-to-day core funding can also present significant liquidity problems - either during times of
market turbulence or if there are difficulties specific to the institution itself. As applicable, the
Agencies will provide further guidance on the liquidity risk associated with over reliance on asset
securitizations as a funding source and implicit recourse obligations.
CONTENTS
Page
Description of Activity ...................................................................................................2
Independent Risk Management Function .......................................................................4
Valuation and Modeling Process ....................................................................................6
Use of Outside Parties .....................................................................................................7
Internal Controls ..............................................................................................................7
Audit Function or Internal Review ..................................................................................7
Regulatory Reporting ......................................................................................................8
Market Discipline and Disclosures ..................................................................................9
Risk-Based Capital for Recourse and Low Level Recourse Transactions ......................9
Institution Imposed Concentration Limits on Retained Interests ..................................10
Summary ........................................................................................................................11
DESCRIPTION OF ACTIVITY
Asset securitization typically involves the transfer of on-balance sheet assets to a third party or
trust. In turn the third party or trust issues certificates or notes to investors. The cash flow from
the transferred assets supports repayment of the certificates or notes. For several years, large
financial institutions, and a growing number of regional and community institutions, have been
using asset securitization to access alternative funding sources, manage concentrations, improve
financial performance ratios, and more efficiently meet customer needs. In many cases, the
discipline imposed by investors who buy assets at their fair value has sharpened selling
institutions’ credit risk selection, underwriting, and pricing practices. Assets typically securitized
by institutions include credit card receivables, automobile receivable paper, commercial and
residential first mortgages, commercial loans, home equity loans, and student loans.
While the Agencies continue to view the use of securitization as an efficient means of financial
intermediation, we are concerned about events and trends uncovered at recent examinations. Of
particular concern are institutions that are relatively new users of securitization techniques and
institutions whose senior management and directors do not have the requisite knowledge of the
effect of securitization on the risk profile of the institution or are not fully aware of the
accounting, legal and risk-based capital nuances of this activity. Similarly, the Agencies are
concerned that some institutions have not fully and accurately distinguished and measured the
risks that have been transferred versus those retained, and accordingly are not adequately
managing the retained portion. It is essential that institutions engaging in securitization activities
have appropriate front and back office staffing, internal and external accounting and legal
Date:
December 13, 1999
Page 2
support, audit or independent review coverage, information systems capacity, and oversight
mechanisms to execute, record, and administer these transactions correctly.
Additionally, we are concerned about the use of inappropriate valuation and modeling
methodologies to determine the initial and ongoing value of retained interests. Accounting rules
provide a method to recognize an immediate gain (or loss) on the sale through booking a
“retained interest;” however, the carrying value of that interest must be fully documented, based
on reasonable assumptions, and regularly analyzed for any subsequent value impairment. The
best evidence of fair value is a quoted market price in an active market. In circumstances where
quoted market prices are not available, accounting rules allow fair value to be estimated. This
estimate must be based on the "best information available in the circumstances."2 An estimate of
fair value must be 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.
History shows that unforeseen market events that affect the discount rate or performance of
receivables supporting a retained interest can swiftly and dramatically alter its value. Without
appropriate internal controls and independent oversight, an institution that securitizes assets may
inappropriately generate “paper profits” or mask actual losses through flawed loss assumptions,
inaccurate prepayment rates, and inappropriate discount rates. Liberal and unsubstantiated
assumptions can result in material inaccuracies in financial statements, substantial write-downs
of retained interests, and, if interests represent an excessive concentration of the institution’s
capital, the demise of the sponsoring institution.
Recent examinations point to the need for institution managers and directors to ensure that:
•
Independent risk management processes are in place to monitor securitization pool
performance on an aggregate and individual transaction level. An effective risk management
function includes appropriate information systems to monitor securitization activities.
•
Conservative valuation assumptions and modeling methodologies are used to establish,
evaluate and adjust the carrying value of retained interests on a regular and timely basis.
•
Audit or internal review staffs periodically review data integrity, model algorithms, key
underlying assumptions, and the appropriateness of the valuation and modeling process for
the securitized assets retained by the institution. The findings of such reviews should be
reported directly to the board or an appropriate board committee.
•
Accurate and timely risk-based capital calculations are maintained, including recognition and
reporting of any recourse obligation resulting from securitization activity.
•
Internal limits are in place to govern the maximum amount of retained interests as a
percentage of total equity capital.
•
The institution has a realistic liquidity plan in place in case of market disruptions.
2
Date:
FAS 125, at par. 43
December 13, 1999
Page 3
The following sections provide additional guidance relating to these and other critical areas of
concern. Institutions that lack effective risk management programs or that maintain exposures in
retained interests that warrant supervisory concern may be subject to more frequent supervisory
review, more stringent capital requirements, or other supervisory action.
INDEPENDENT RISK MANAGEMENT FUNCTION
Institutions engaged in securitizations should have an independent risk management function
commensurate with the complexity and volume of their securitizations and their overall risk
exposures. The risk management function should ensure that securitization policies and
operating procedures, including clearly articulated risk limits, are in place and appropriate for the
institution’s circumstances. A sound asset securitization policy should include or address, at a
minimum:
•
A written and consistently applied accounting methodology;
•
Regulatory reporting requirements;
•
Valuation methods, including FAS 125 residual value assumptions, and procedures to
formally approve changes to those assumptions;
•
Management reporting process; and
•
Exposure limits and requirements for both aggregate and individual transaction monitoring.
It is essential that the risk management function monitor origination, collection, and default
management practices. This includes regular evaluations of the quality of underwriting,
soundness of the appraisal process, effectiveness of collections activities, ability of the default
management staff to resolve severely delinquent loans in a timely and efficient manner, and the
appropriateness of loss recognition practices. Because the securitization of assets can result in
the current recognition of anticipated income, the risk management function should pay
particular attention to the types, volumes, and risks of assets being originated, transferred and
serviced. Both senior management and the risk management staff must be alert to any pressures
on line managers to originate abnormally large volumes or higher risk assets in order to sustain
ongoing income needs. Such pressures can lead to a compromise of credit underwriting
standards. This may accelerate credit losses in future periods, impair the value of retained
interests and potentially lead to funding problems.
The 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 has helped well-managed institutions to 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 hinders management’s
ability to monitor specific pool performance and securitization activities more broadly. At a
minimum, MIS reports should address the following:
Date:
December 13, 1999
Page 4
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 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 performance of assets, both on an
individual pool basis and total managed assets. These reports should segregate specific
products and different marketing campaigns.
Vintage analysis for each pool using monthly data - Vintage analysis helps 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 to 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 - This analysis entails 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 the timing and amount of cash flows received from the trust with those
projected as part of the FAS 125 retained interest valuation analysis on a monthly basis.
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 - Measuring the effect of changes in default rates, prepayment or
payment rates, and discount rates will 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 to consider 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, 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
Date:
December 13, 1999
Page 5
system.3 Examiners will review the analysis conducted by the institution and the volatility
associated with retained interests when assessing the Sensitivity to Market Risk component
rating.
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 overcollateralization requirements, and events that would result in servicer removal.
VALUATION AND MODELING PROCESSES
The method and key assumptions used to value the retained interests and servicing assets or
liabilities must be reasonable and fully documented. The key assumptions in all valuation
analyses include prepayment or payment rates, default rates, loss severity factors, and discount
rates. The Agencies expect institutions to take a logical and conservative approach when
developing securitization assumptions and capitalizing future income flows. It is important that
management quantifies the assumptions on a pool-by-pool basis and maintains supporting
documentation for all changes to the assumptions as part of the valuation process, which should
be done no less than quarterly. Policies should define the acceptable reasons for changing
assumptions and require appropriate management approval.
An exception to this pool-by-pool valuation analysis may be applied to revolving asset trusts if
the master trust structure allows excess cash flows to be shared between series. In a master trust,
each certificate of each series represents an undivided interest in all of the receivables in the trust.
Therefore, valuations are appropriate at the master trust level.
In order to determine the value of the retained interest at inception, and make appropriate
adjustments going forward, the institution must implement a reasonable modeling process to
comply with FAS 125. The Agencies expect management to employ reasonable and
conservative valuation assumptions and projections, and to maintain verifiable objective
documentation of the fair value of the retained interest. Senior management is responsible for
ensuring the valuation model accurately reflects the cash flows according to the terms of the
securitization’s structure. For example, the model should account for any cash collateral or overcollateralization triggers, trust fees, and insurance payments if appropriate. The board and
management are accountable for the “model builders” possessing the necessary expertise and
technical proficiency to perform the modeling process. Senior management should ensure that
internal controls are in place to provide for the ongoing integrity of MIS associated with
securitization activities.
As part of the modeling process, the risk management function should ensure that periodic
validations are performed in order to reduce vulnerability to model risk. Validation of the model
includes testing the internal logic, ensuring empirical support for the model assumptions, and
3
Under the Joint Agency Policy Statement on Interest Rate Risk, institutions with a high level of exposure to
interest rate risk relative to capital will be directed to take corrective action. Savings associations can find OTS
guidance on interest rate risk in Thrift Bulletin 13a - Management of Interest Rate Risk, Investment Securities, and
Derivative Activities.
Date:
December 13, 1999
Page 6
back-testing the models with actual cash flows on a pool-by-pool basis. The validation process
should be documented to support conclusions. Senior management should ensure the validation
process is independent from line management as well as the modeling process. The audit scope
should include procedures to ensure that the modeling process and validation mechanisms are
both appropriate for the institution’s circumstances and executed consistent with the institution's
asset securitization policy.
USE OF OUTSIDE PARTIES
Third parties are often engaged to provide professional guidance and support regarding an
institution's securitization activities, transactions, and valuing of retained interests. The use of
outside resources does not relieve directors of their oversight responsibility, or senior
management of its responsibilities to provide supervision, monitoring, and oversight of
securitization activities, and the management of the risks associated with retained interests in
particular. Management is expected to have the experience, knowledge, and abilities to
discharge its duties and understand the nature and extent of the risks presented by retained
interests and the policies and procedures necessary to implement an effective risk management
system to control such risks. Management must have a full understanding of the valuation
techniques employed, including the basis and reasonableness of underlying assumptions and
projections.
INTERNAL CONTROLS
Effective internal controls are essential to an institution’s management of the risks associated
with securitization. When properly designed and consistently enforced, a sound system of
internal controls will help management safeguard the institution’s resources, ensure that financial
information and reports are reliable, and comply with contractual obligations, including
securitization covenants. It will also reduce the possibility of significant errors and irregularities,
as well as assist in their timely detection when they do occur. Internal controls typically: (1) limit
authorities, (2) safeguard access to and use of records, (3) separate and rotate duties, and (4)
ensure both regular and unscheduled reviews, including testing.
The Agencies have established operational and managerial standards for internal control and
information systems.4 An institution should maintain a system of internal controls appropriate to
its size and the nature, scope, and risk of its activities. Institutions that are subject to the
requirements of FDIC regulation 12 CFR Part 363 should include an assessment of the
effectiveness of internal controls over their asset securitization activities as part of management’s
report on the overall effectiveness of the system of internal controls over financial reporting.
This assessment implicitly includes the internal controls over financial information that is
included in regulatory reports.
AUDIT FUNCTION OR INTERNAL REVIEW
4
Date:
Safety and Soundness Standards 12 CFR Part 30 (OCC), 12 CFR Part 570 (OTS).
December 13, 1999
Page 7
It is the responsibility of an institution’s board of directors to ensure that its audit staff or
independent review function is competent regarding securitization activities. The audit function
should perform periodic reviews of securitization activities, including transaction testing and
verification, and report all findings to the board or appropriate board committee. The audit
function also may be useful to senior management in identifying and measuring risk related to
securitization activities. Principal audit targets should include compliance with securitization
policies, operating and accounting procedures (FAS 125), and deal covenants, and accuracy of
MIS and regulatory reports. The audit function should also confirm that the institution’s
regulatory reporting process is designed and managed in such a way to facilitate timely and
accurate report filing. Furthermore, when a third party services loans, the auditors should perform
an independent verification of the existence of the loans to ensure balances reconcile to internal
records.
REGULATORY REPORTING
The securitization and subsequent removal of assets from an institution’s balance sheet requires
additional reporting as part of the regulatory reporting process. Common regulatory reporting
errors stemming from securitization activities include:
•
Failure to include off-balance sheet assets subject to recourse treatment when calculating
risk-based capital ratios;
•
Failure to recognize retained interests and retained subordinate security interests as a form of
credit enhancement;
•
Failure to report loans sold with recourse in the appropriate section of the regulatory report;
and
•
Over-valuing retained interests.
An institution’s directors and senior management are responsible for the accuracy of its
regulatory reports. Because of the complexities associated with securitization accounting and
risk-based capital treatment, attention should be directed to ensuring that personnel who prepare
these reports maintain current knowledge of reporting rules and associated interpretations. This
often will require ongoing support by qualified accounting and legal personnel.
Institutions that file the Report of Condition and Income (Call Report) should pay particular
attention to the following schedules on the Call Report when institutions are involved in
securitization activities: Schedule RC-F: Other Assets; Schedule RC-L: Off Balance Sheet Items;
and Schedule RC-R: Regulatory Capital. Institutions that file the Thrift Financial Report (TFR)
should pay particular attention to the following TFR schedules: Schedule CC: Consolidated
Commitments and Contingencies, Schedule CCR: Consolidated Capital Requirement, and
Schedule CMR: Consolidated Maturity and Rate.
Under current regulatory report instructions, when an institution’s supervisory agency’s
interpretation of how generally accepted accounting principles (GAAP) should be applied to a
Date:
December 13, 1999
Page 8
specified event or transaction differs from the institution’s interpretation, the supervisory agency
may require the institution to reflect the event or transaction in its regulatory reports in
accordance with the agency’s interpretation and amend previously submitted reports.
MARKET DISCIPLINE AND DISCLOSURES
Transparency through public disclosure is crucial to effective market discipline and can reinforce
supervisory efforts to promote high standards in risk management. Timely and adequate
information on the institution’s asset securitization activities should be disclosed. The
information contained in the disclosures should be comprehensive; however, the amount of
disclosure that is appropriate will depend on the volume of securitizations and complexity of the
institution. Well-informed investors, depositors, creditors and other bank counterparties can
provide a bank with strong incentives to maintain sound risk management systems and internal
controls. Adequate disclosure allows market participants to better understand the financial
condition of the institution and apply market discipline, creating incentives to reduce
inappropriate risk taking or inadequate risk management practices. Examples of sound
disclosures include:
•
Accounting policies for measuring retained interests, including a discussion of the impact of
key assumptions on the recorded value;
•
Process and methodology used to adjust the value of retained interests for changes in key
assumptions;
•
Risk characteristics, both quantitative and qualitative, of the underlying securitized assets;
•
Role of retained interests as credit enhancements to special purpose entities and other
securitization vehicles, including a discussion of techniques used for measuring credit risk;
and
•
Sensitivity analyses or stress testing conducted by the institution showing the effect of
changes in key assumptions on the fair value of retained interests.
RISK-BASED CAPITAL FOR RECOURSE AND LOW LEVEL RECOURSE
TRANSACTIONS
For regulatory purposes, recourse is generally defined as an arrangement in which an institution
retains the risk of credit loss in connection with an asset transfer, if the risk of credit loss exceeds
a pro rata share of the institution’s claim on the assets.5 In addition to broad contractual language
that may require the selling institution to support a securitization, recourse can also arise from
retained interests, retained subordinated security interests, the funding of cash collateral accounts,
or other forms of credit enhancements that place an institution’s earnings and capital at risk.
5
The risk-based capital treatment for sales with recourse can be found at 12 CFR Part 3 Appendix A, Section
(3)(b)(1)(iii) {OCC}, 12 CFR Part 567.6(a)(2)(i)(c) {OTS}. For a further explanation of recourse see the glossary
entry "Sales of Assets for Risk-Based Capital Purposes" in the instructions for the Call Report.
Date:
December 13, 1999
Page 9
These enhancements should generally be aggregated to determine the extent of an institution’s
support of securitized assets. Although an asset securitization qualifies for sales treatment under
GAAP, the underlying assets may still be subject to regulatory risk-based capital requirements.
Assets sold with recourse should generally be risk-weighted as if they had not been sold.
Securitization transactions involving recourse may be eligible for “low level recourse”
treatment.6 The Agencies’ risk-based capital standards provide that the dollar amount of riskbased capital required for assets transferred with recourse should not exceed the maximum dollar
amount for which an institution is contractually liable. The “low level recourse” treatment
applies to transactions accounted for as sales under GAAP in which an institution contractually
limits its recourse exposure to less than the full risk-based capital requirements for the assets
transferred. Under the low level recourse principle, the institution holds capital on approximately
a dollar-for-dollar basis up to the amount of the aggregate credit enhancements.
Low level recourse transactions should be reported in Schedule RC-R of the Call Report or
Schedule CCR of the TFR using either the “direct reduction method” or the “gross-up method”
in accordance with the regulatory report instructions.
If an institution does not contractually limit the maximum amount of its recourse obligation, or if
the amount of credit enhancement is greater than the risk-based capital requirement that would
exist if the assets were not sold, the low level recourse treatment does not apply. Instead, the
institution must hold risk-based capital against the securitized assets as if those assets had not
been sold.
Finally, as noted earlier, retained interests that lack objectively verifiable support or that fail to
meet the supervisory standards set for in this document will be classified as loss and disallowed
as assets of the institution for regulatory capital purposes.
INSTITUTION IMPOSED CONCENTRATION LIMITS ON RETAINED INTERESTS
The creation of a retained interest (the debit) typically also results in an offsetting “gain on sale”
(the credit) and thus generation of an asset. Institutions that securitize high yielding assets with
long durations may create a retained interest asset value that exceeds the risk-based capital
charge that would be in place if the institution had not sold the assets (under the existing riskbased capital guidelines, capital is not required for the amount over eight percent of the
securitized assets). Serious problems can arise for institutions that distribute contrived earnings
only later to be faced with a downward valuation and charge-off of part or all of the retained
interests.
As a basic example, an institution could sell $100 in subprime home equity loans and book a
retained interest of $20 using liberal “gain on sale” assumptions. Under the current capital rules,
6
The banking agencies’ low level recourse treatment is described in the Federal Register in the following locations:
60 Fed. Reg. 17986 (April 10, 1995) (OCC); 60 Fed. Reg. 8177 (February 13, 1995)(FRB); 60 Fed. Reg. 15858
(March 28,1995)(FDIC). OTS has had a low level recourse rule in 12 CFR Part 567.6(a)(2)(i)(c) since 1989. A brief
explanation is also contained in the instructions for regulatory reporting in section RC-R for the Call Report or
schedule CCR for the TFR.
Date:
December 13, 1999
Page 10
the institution is required to hold approximately $8 in capital. This $8 is the current capital
requirement if the loans were never removed from the balance sheet (eight percent of $100 = $8).
However, the institution is still exposed to substantially all of the credit risk, plus the additional
risk to earnings and capital from the volatility of the retained interest. If the value of the retained
interest decreases to $10 due to inaccurate assumptions or changes in market conditions, the $8
in capital is insufficient to cover the entire loss.
Normally, the sponsoring institution will eventually receive any excess cash flow remaining from
securitizations after investor interests have been met. However, recent experience has shown that
retained interests are vulnerable to sudden and sizeable write-downs that can hinder an
institution’s access to the capital markets, damage its reputation in the market place, and in some
cases, threaten its solvency. Accordingly, the Agencies expect an institution's board of directors
and management to develop and implement policies that limit the amount of retained interests
that may be carried as a percentage of total equity capital, based on the results of their valuation
and modeling processes. Well constructed internal limits also serve to lessen the incentive of
institution personnel to engage in activities designed to generate near term “paper profits” that
may be at the expense of the institution’s long term financial position and reputation.
SUMMARY
Asset securitization has proven to be an effective means for institutions to access new and
diverse funding sources, manage concentrations, improve financial performance ratios, and
effectively serve borrowing customers. However, securitization activities also present unique
and sometimes complex risks that require board and senior management attention. Specifically,
the initial and ongoing valuation of retained interests associated with securitization, and the
limitation of exposure to the volatility represented by these assets, warrant immediate attention
by management.
Moreover, as mentioned earlier in this statement, the Agencies are studying various issues
relating to securitization practices, including whether restrictions should be imposed that would
limit or eliminate the amount of retained interests that qualify as regulatory capital. In the
interim, the Agencies will review affected institutions on a case-by-case basis and may require, in
appropriate circumstances, that institutions hold additional capital commensurate with their risk
exposure. In addition, the Agencies will study, and issue further guidance on, institutions'
exposure to implicit recourse obligations and the liquidity risk associated with over reliance on
asset securitization as a funding source.
Date:
December 13, 1999
Page 11
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