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Asset Securitization Supervisory Perspective


									October 1989

Asset Securitization: A Supervisory
Thomas R. Boemio and Gerald A. Edwards, Jr.,           AN OVERVIEW       OF ASSET      SECURITIZATION
of the Board's Division of Banking Supervision
and Regulation prepared this article. Michael          In its simplest form, asset securitization involves
Boennighausen contributed research assistance.         the selling of assets. The process first segregates
                                                       generally illiquid assets into pools and transforms
                                                       these pools into capital market instruments. The
In recent years the number of banks and bank           payment of principal and interest on these instru-
holding companies (referred to here as banking         ments depends on the cash flows from the assets
organizations) that have issued securities             in the pool that underlies the new securities. The
backed by their assets and that have acquired          new securities may differ from their underlying
asset-backed securities as investments has in-         assets in terms of denominations, cash flows, and
creased markedly. The reason for this increase         other features that make the securities more
is that securitization activities, if conducted in a   attractive to investors.
prudent manner, can yield significant financial           Asset securitization, as we know it, began
and operational benefits for banking organiza-         when the federal government encouraged the
tions. At the same time, bank supervisors must         securitization of residential mortgages. In 1970,
carefully assess the effect of asset securitization    the Government National Mortgage Association
activities on the financial condition, perfor-         (GNMA) created the first publicly traded mort-
mance, and risk profiles of banking organiza-          gage-backed security. Soon, the Federal Na-
tions.                                                 tional Mortgage Association (FNMA) and the
   This article examines asset securitization          Federal Home Loan Mortgage Corporation
from a supervisory perspective. The first sec-         (FHLMC), both government-sponsored agen-
tion describes the mechanics of the securitiza-        cies, also developed mortgage-backed securities.
tion process, the structures of asset-backed           The guarantees that these government or govern-
securities, and the involvement of banking or-         ment-sponsored agencies provide, which assure
ganizations in this process. It also discusses the     investors of the payment of principal and inter-
incentives for issuing and acquiring asset-            est, have greatly facilitated the securitization of
backed securities.                                     mortgage assets.
   The second section outlines the supervisory            Asset securitization has grown dramatically
issues associated with ownership or issuance of        over the past few years. The outstanding amount
asset-backed securities by banking organizations       of residential mortgage-backed, pass-through se-
and the supervisory policies and procedures used       curities, which are the largest segment of the
by the Federal Reserve System in light of the          asset-backed securities market, has increased
growing involvement of banking organizations in        approximately 168 percent since year-end 1984 to
asset securitization. It summarizes generally ac-      $769 billion by year-end 1988 (table 1). In addi-
cepted accounting principles (GAAP) and bank           tion to rapid growth in residential mortgage-
regulatory reporting requirements as they pertain      backed securities, recent years have witnessed
to sales treatment of asset securitization transac-    an explosion in the issuance of securities backed
tions. This section also examines the provisions       by other assets: credit card receivables, automo-
of the risk-based capital guidelines that relate to    bile loans, boat loans, commercial real estate
the asset securitization process.                      loans, home equity loans, student loans, nonper-
October 1989

660 lederal Reserve Bulletin !~l October 1989

   Omstantlinti amount of pa^s-throujzli                                       rities are either guaranteed directly by (iNMA, a
   kicked by residentiiil mongiigo                                             government agency backed by the full faith and
    lillllOIK 1)1   clolliu-,
                                                                               credit of the U.S. government, or by IN MA or
                                Type "'" pass-through
                                                                               I'lH.MC, government-sponsored agencies that
      Year                                                            Total
                                                                               are not backed by the full faith and credit of the
                     GNMA       FHLMC       FNMA
                                                         Private               U.S. government but are perceived by the credit
                                                                               markets to have its implicit support. Privately
  1984                 180.0       70.8       36.2        n.a.        287.0    issued, mortgage-backed securities and other
  1985                 212.1      100.4       55.0        n.a.        367.5    types of asset-backed securities generally depend
  1986                 262.7      171.4       97.2         6.3        537.6
  1987                 317.6      212.6      140.0        14.0        684.2    on some form of credit enhancement provided by
  1988                 340.5      225.0      178.3        25.1        768.9
                                                                               the originator or third party to insulate the inves-
  I. Tin- IOIIR'C for IIICM: &,ilh is I World ]'llhlic;i[ions.      tor from some or all of any credit losses. Usually,
  n.u   Nul iiviiiliihlo.                                                      credit enhancement is provided for several mul-
                                                                               tiples of the historical losses experienced on ihe
forming loans, and lease receivables. The annual                               particular asset backing the security.
issuance of securities backed by assets other                                     One form of credit enhancement is the re-
than mortgages has increased from slightly more                               course provision, or guarantee, that requires
than %\ billion in 1985 to more than SI6 billion by                           the originator to cover any losses up to an
(he end of 1988.                                                              amount contractually agreed upon. Some asset-
                                                                               backed securities, such as those backed by
Hit' S<'ciiiiti:iiiion I'roci's.s                                             credit card receivables, typically use a "spread
                                                                              account." This account is actually an escrow
 The asset sccuriti/ation process begins, as de-                              account whose funds are derived from a portion
picted in the chart, with the segregation of loans                            of the spread between the interest earned on the
or leases into pools that arc relatively homoge-                              assets in the underlying pool and the lower
neous with respect to type of credit, maturity,                               interest paid on securities issued by the trust.
and interest rate risk. These pools of assets are                              The amounts that accumulate in the account are
then transferred to a trust or other entity known                             used to cover credit losses in the underlying
as an issuer because it issues the securities that                            asset pool up to several multiples of historical
are acquired by investors. These asset-backed                                 losses on the underlying assets.
securities may take the form of debt, certifi-                                    Overcollatcrali/ation, another form of credit
cates of beneficial ownership, or other instru-                               enhancement covering a predetermined amount
ments. The issuer is typically protected from                                 of potential credit losses, occurs when the value
bankruptcy by various structural and legal ar-                                of the underlying assets exceeds the face value of
rangements. A sponsor that provides the assets                                the securities. Also, ihc senior-subordinated se-
to be securitized owns or otherwise establishes                               curity structure provides credit enhancement,
the issuer.                                                                   generally to the senior class. Under such a struc-
   Ivach issue of asset-backed securities has a                               ture, at least two classes of asset-backed securi-
servicer responsible for collecting interest and                              ties are issued, with the senior class having a
principal payments on the loans or leases in the                              priority claim on the cash flows from the under-
underlying pool of assets and for transmitting                                lying pool of assets. Since the senior class has
these funds to investors (or a trustee representing                           this priority claim, cash flows from the underly-
them). A trustee monitors the activities of scr-                              ing pool of assets must first satisfy the require-
vicers to ensure that they properly fulfill their                             ments of the senior class. Only after these re-
role.                                                                         quirements have been met will the cash flows be
  A guarantor may also be involved to sec that                                directed to service the subordinated class. There-
principal and interest payments will be received                              fore, the subordinated class must absorb credit
by investors on a timely basis, even if the ser-                              losses before any are charged to the senior
vicer is unable to collect these payments from the                            portion. Other forms of credit enhancement in-
obligors. Many issues of mortgage-backed .secu-                               clude standby letters of credit or surely bonds
October 1989

                                                     Asset Securitizdtion: A Supervisory Perspective              661

 IVoin third parties that protect investors against          zations securitize their assets and these transac-
 losses.                                                     tions are treated as sales, both the assets and the
    An investment banking firm or oilier organiza-           related asset-backed securities (that is, liabilities)
 tion generally serves as an imderw riter for asset-         are removed from the balance sheel. The cash
 backed securities. In addition, for asset-backed            proceeds from the securiti/ation transactions arc
 issues that are publicly ottered, a credit rating           generally used to originate or acquire additional
 agency will analyze the policies and operations of          loans or other assets for securitizalion. and the
 the originator and servicer, as well as the struc-          process is then repeated. Thus, for the same
 ture, underlying pool of assets, expected cash              volume of loan originations, securitizalion re-
 Hows, and other attributes of such securities.              sults in lower amounts of assets and liabilities
 Before assigning a rating to the issue, the rating          when compared with traditional lending activi-
 agency will also assess the extent of loss protec-          ties.
 tion provided to investors by any credit enhance-
 ments associated with (he issue. (See the chart.)
    Traditional lending activities are generally             The Structure <>f
 funded by deposits or other liabilities, and both           Asset-Hacked Securities
 the assets and related liabilities are reflected on
 the balance sheet. Deposit liabilities must gener-         Asset securiti/ation involves different kinds of
 ally increase to fund additional loans.                    capital market instruments. These instruments
    In contrast, the securiti/ation process gener-          may be structured as "pass-throughs" or "pay-
 ally does not increase on-balance-sheet liabilities        Ihroughs." Under a pass-through structure, the
 in proportion \o the volume of loans or other              cash Hows from the underlying pool of assets
 assets being originated and securitized. As dis-           are passed through to investors on a pro rata
 cussed more fully below, when banking organi-              basis. This type of security is typically a single-

 Pass-ilirouyli. asset hacked socuriiies: structure and cash flows

                       principal ui\d                                  "Passes through" principal and
                          interest                                           interest payments
        Remit •
 principal and I
       interest|        Initial cash                     Initial cash                      Initial cash
     payments.           proceeds                         proceeds                          purchase
                            from                             from                               of
         Originator/     securities                       securities                        securities
          Sponsor/                                                         Underwriter                    Investors
          Servicer       Transfers                          Issues                         Distributes
                          loans on                        securities                       securities
                        receivables       Provides credit
    Purchases                             enhancement for the
        credit                            asset pool, for example,
 enhancement                              by a letter of credit

                                Credit                                                    Cash flows
                               enhancer                                                   Structure
October 1989

662 Federal Reserve Bulletin D October 1989

class instrument such as a GNMA pass-                ests"), represents claims on any cash flows that
through. The pay-through structure, which has        remain after all obligations to investors and any
multiple classes, combines the cash flows from       related expenses have been met. Such excess
the underlying pool of assets and reallocates        cash flows may result from overcollateraliza-
them to two or more issues of securities that        tion or from reinvestment income. Residuals
have different cash flow characteristics and         can be retained by sponsors or purchased by
maturities. An example is the collateralized         investors in the form of securities.
mortgage obligation (CMO), which has a series
of bond classes, each with its own specified         Involvement of
coupon and stated maturity. In most cases, the       Banking Organizations
assets that make up the CMO collateral pools
are pass-through securities backed by residen-       Banking organizations have long been involved
tial mortgages. Scheduled principal payments,        in asset securitization, particularly in the well-
and any prepayments, from the underlying col-        developed market for securities backed by res-
lateral go first to the earliest maturing class of   idential mortgages. More recently, banking or-
bonds. This first class of bonds must be retired     ganizations, besides substantially augmenting
before the principal cash flows are used to retire   the volume of their activities in this area, have
the later bond classes. The development of the       also started securitizing other types of assets,
pay-through structure was a result of the desire     as mentioned earlier, particularly credit card
to broaden the marketability of these securities     receivables. Also, many banking organizations
to investors who were interested in maturities       have increased their reliance on securitization
other than those generally associated with pass-     for funding, have acted as servicers or trustees
through securities.                                  for securitized issues, and have purchased as-
   Multiple-class, asset-backed securities may       set-backed securities or derivative instruments
also be issued as derivative instruments such as     for investment or other purposes.
"stripped" securities. Investors in each class of       Currently, securities subsidiaries of bank
a stripped security will receive a different por-    holding companies may underwrite asset-
tion of the principal and interest cash flows        backed securities originated by third parties as
from the underlying pool of assets. In their         long as the criteria of the Federal Reserve
purest form, stripped securities may be issued       Board's section 20 orders are met.1 In June
as interest-only (10) strips for which investors     1987, the Comptroller of the Currency (OCC)
receive 100 percent of the interest from the         permitted national banks to underwrite securi-
underlying pool of assets and as principal-only      ties backed by their own assets. This decision
(PO) strips for which the investors receive all of   was challenged, and in December 1988, a fed-
the principal.                                       eral district court ruled that such underwriting
   In addition to these securities, other types of   activities were in violation of the Glass-Steagall
financial instruments may arise as a result of       Act. The decision was recently reversed upon
asset securitization. One such instrument is         appeal by the OCC.
loan servicing rights that are created when
organizations purchase the right to act as ser-
vicers 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          1. In April and May 1987, the Board approved applications
financial instrument, generally arise when the       to underwrite and deal in, to a limited extent, one- to
                                                     four-family mortgage-related securities that are rated as in-
cash flows from the underlying assets that a         vestment quality (that is, one of the top four categories) by a
servicer expects to receive exceed standard          nationally recognized rating agency. The Board found that
normal servicing fees. Another instrument, as-       these proposals, as limited in the Order, are consistent with
                                                     section 20 of the Glass-Steagall Act. In addition, the Board
set-backed securities residuals (sometimes re-       approved applications, in July 1987, to underwrite and deal
ferred to as "residuals" or "residual inter-         in, on a limited basis, consumer-receivable-related securities.
October 1989

                                                     Asset Securitization: A Supervisory Perspective        663

   Banking organizations securitize assets to accom-       SUPERVISORY CONSIDERATIONS, POLICIES,
plish several objectives. First, in selling rather than    AND PROCEDURES REGARDING
holding the originated assets, banking organizations       ASSET SECURITIZATION
are able to lower liabilities and assets and, therefore,
reduce their reserve and capital requirements and          While clear benefits accrue to banking organiza-
deposit insurance premiums. Securitization also            tions that engage in securitization activities and
provides an additional source of funding, generally        that invest in asset-backed securities, these ac-
at a lower cost than other funding sources. At the         tivities have the potential of increasing the over-
same time, the organization can earn fee income            all risk profile of the banking organization if they
from originating loans that are sold and by then           are not carried out in a prudent manner. For the
servicing those loans.                                     most part, the risks that financial institutions
   Decisions to sell rather than hold loans that are       encounter in the securitization process are iden-
used to back securities also affect the timing for         tical to those that they face in traditional lending
recording fee revenue in the income statement.             transactions. These involve credit risk, concen-
Once the sales are completed, banking organiza-            tration risk, operational risk, liquidity risk, fund-
tions can immediately recognize income from (I)            ing risk, and interest rate risk—including prepay-
syndication fees, (2) previously deferred loan             ment risk. However, since the securitization
fees related to loans that are sold, and (3) any           process separates the traditional lending function
excess servicing fees created by the asset secu-           into several limited roles, such as originator,
ritization process.                                        servicer, credit enhancer, trustee, and investor,
   Thus, asset sales boost standard income mea-            the types of risks that a bank will encounter will
sures, such as return on assets, in two ways.              differ depending on the role it assumes.
They serve to bolster income in the period of the             As with direct investments in the underlying
sale through the generation of fees while reduc-           assets, investors in asset-backed securities will
ing the total volume of assets and thus raising the        be exposed to credit risk, that is, the risk that
return on assets ratio. By creating a process, or          obligors will default on principal and interest
"pipeline," that continually originates and secu-          payments. Investors are also subject to the risk
ritizes assets, thereby removing them from the             that the various parties in the securitization pro-
balance sheet, a banking organization can use its          cess, for example, the servicer or trustee, will be
systems and loan expertise to originate loans that         unable to fulfill their contractual obligations.
otherwise might not be made. Thus, a banking               Moreover, investors may be susceptible to con-
organization can increase its share of markets for         centrations of risks across various asset-backed
particular types of loans without the deteriora-           security issues through overexposure to an orga-
tion of its capital ratios.                                nization performing several roles in the securiti-
   The largest purchasers of asset-backed securi-          zation process or as a result of geographic con-
ties have been pension funds, insurance compa-             centrations within the pool of assets providing
nies, savings and loan associations, and commer-           the cash flows for an individual issue. Since the
cial banks. Investors tend to be risk averse.              secondary markets for certain asset-backed se-
Thus, asset-backed securities are attractive in-           curities are thin, investors may also encounter
vestments because they are considered relatively           greater-than-anticipated difficulties in selling
safe as a result of the government or government-          their securities. Furthermore, certain derivative
sponsored agencies' guarantees or because of               instruments, such as stripped, asset-backed se-
private credit enhancements. Also, the returns             curities and residuals, may be extremely sensi-
on asset-backed securities are typically higher            tive to interest rates and volatile in price. There-
than those on U.S. Treasury securities with                fore, these instruments may dramatically affect
                                                           the risk exposure of investors unless they are
comparable maturities. Furthermore, investors
                                                           used in a properly structured hedging strategy.
are able to diversify their portfolio by acquiring
different types of assets, for example, mortgages            Banking organizations that issue asset-backed
or credit card receivables, from different geo-            securities may be subject to pressures to sell only
graphic areas.                                             their best assets—thus reducing the quality of
October 1989

664 Federal Reserve Bulletin • October 1989

their own loan portfolios. On the other hand,         alized borrowing, that is, a financing transac-
some banking organizations may feel pressures         tion secured by assets. Sales treatment results
to relax their credit standards because they can      in the removal of the assets from the banking
sell assets with higher risk than those they nor-     organization's balance sheet, thus reducing to-
mally would retain for their own portfolios.          tal assets relative to earnings and capital, and
   Banking organizations that service securitiza-     thereby producing higher performance and cap-
tion issues must ensure that their policies, oper-    ital ratios. Treatment of these transactions as
ations, and systems will not permit breakdowns        financings, however, means that the assets in
that may lead to defaults. Issuers and servicers      the pool remain on the balance sheet and are
may face pressures to provide "moral recourse"        subject to capital requirements, and the related
by repurchasing securities backed by loans or         liabilities are subject to reserve requirements.2
leases they have originated that have deterio-        From a supervisory standpoint, outright sales
rated and become nonperforming. Funding risk          do not present a problem in that such transac-
may also be a problem for issuers when market         tions transfer all of the risks and rewards of
aberrations do not permit the timely issuance of      ownership of the underlying assets. On the
asset-backed securities that are in the securitiza-   other hand, transfers that involve recourse to
tion pipeline.                                        the selling institution, if treated as sales, can
   In view of the increasing involvement of bank-     result in credit risk that is not reflected on the
ing organizations in the asset securitization pro-    balance sheet of that institution.
cess and the desire to foster prudent banking            For bank holding companies and their non-
practice with respect to this activity, the Federal   bank affiliates, or for any other nonbank entity
Reserve and the other banking regulators have         publishing audited financial statements, these
taken several steps over the years to address         accounting treatments are determined by
securitization activities. These include (1) main-    GAAP. Bank holding companies also follow
tenance of regulatory reporting requirements for      GAAP when preparing regulatory reports filed
sales treatment that discourage banks from re-        with the Federal Reserve. Insured commercial
taining credit risk when securitizing their assets;   banks, on the other hand, must report asset
(2) issuance of an interagency supervisory policy     securitization transactions in accordance with
statement, which discusses investments in             regulatory reporting requirements set forth in
stripped, asset-backed securities and residual        the instructions for the commercial bank Re-
interests; (3) development of the risk-based cap-     ports of Condition and Income (Call Reports).
ital framework; and (4) development of examina-       The federal banking agencies jointly determine
tion guidelines for various aspects of the securi-    these reporting requirements, which are pub-
tization process.                                     lished by the Federal Financial Institutions Ex-
                                                      amination Council (FFIEC). While these regu-
 Sales versus Financing Treatment                     latory reporting requirements usually follow
for Reporting Purposes                                GAAP, special reporting requirements apply to
                                                      sales of assets, including those involved in asset
Asset securitization transactions are frequently      securitization. When asset transfers do not in-
structured to obtain certain accounting treat-        volve recourse to the selling institution, then
ments, which, in turn, affect reported measures       both GAAP and regulatory reporting require-
of profitability and capital adequacy. These mea-     ments are consistent.
sures are used extensively in analyses performed
by supervisory agencies and by the public to
assess the financial condition and performance of
banking organizations.                                   2. Note, however, that the Federal Reserve's Regulation D
   In transferring assets into a pool to serve as     (Reserve Requirements of Depository Institutions) defines
collateral for asset-backed securities, a key         what constitutes a reservable liability of a depository institu-
                                                      tion. Thus, although a given transaction may qualify as an
question is whether the transfer should be            asset sale for Call Report purposes, it nevertheless could
treated as a sale of the assets or as a collater-     result in a reservable liability under Regulation D.
October 1989

                                                      Asset Securitization: A Supervisory Perspective           665

 Sales Treatment                                           therein, less the unearned portion of these fees
for Financial Reporting         Purposes                   and charges).4

Under GAAP, an asset sale occurs when both the             Sales Treatment for Call Report Purposes
risks and rewards of ownership have been trans-
ferred to the purchaser. Thus, asset transfers for         The Call Report instructions for commercial
securitization that do not involve direct or indi-         banks contain a general rule that applies to all
rect recourse to the transferring banking organi-          "sales of assets," other than participations in
zation are treated as sales. When asset transfers          pools of residential mortgages. This instruction
involve recourse, on the other hand, sales or              provides that a transfer of loans or other assets is
financing treatment is determined by the criteria          reported as a sale "only if the transferring insti-
specified by Financial Accounting Standards                tution (1) retains no risk of loss from the assets
Board Statement No. 77 (FASB 77).3                         transferred resulting from any cause and (2) has
   FASB 77 defines recourse as the right of a              no obligation to any party for the payment of
transferee of assets to receive payment from the           principal or interest on the assets transferred
transferor for the "failure of the debtors to pay          resulting from any cause." A transfer involving
when due, effects of prepayments, or adjust-               any retention of risk or obligation for payment,
ments resulting from defects in the eligibility of         even if limited under the terms of the transfer
the transferred receivables." This standard es-            agreement, is generally considered a borrowing
tablishes the following criteria that, if satisfied,       transaction, and the entire amount of the assets
permit a transfer of receivables with recourse to          transferred must remain on the books of the
be considered a sale of the assets rather than a           transferring institution. This risk retention may
financing transaction:                                     occur directly as a result of recourse provisions
   1. The transferor surrenders control of the             or, indirectly, as a result of retaining a subordi-
future economic benefits relating to the receiv-           nated class of an asset-backed security or by
ables.                                                     some other means. Thus, securitization transac-
   2. The transferor can reasonably estimate its           tions involving recourse to the originator will
obligation under the recourse provisions.                  generally be reported as financings for Call Re-
                                                           port purposes.
   3. The transferee cannot return the receivables
to the transferor except pursuant to the recourse             As an exception to the general rule, under the
provisions.                                                separate Call Report instruction for "participa-
When the transfer of assets is deemed a sale in            tion in pools of residential mortgages," banks
accordance with these criteria, the assets that            engaging in the disposal of residential mortgage
have been sold are removed from the transferor's           loan pools under the programs of GNMA,
balance sheet.                                             FNMA, and FHLMC are able to treat such
   At the same time, the amount of losses esti-            transactions as sales of the underlying mortgages
mated to accrue to the seller under the recourse           without regard to the amount of risk retained by
provisions must be recorded as a direct liability          the seller.
on the seller's books. This balance sheet liability           Banks that sell "private" certificates of partic-
(the recourse liability account) must be periodi-          ipation in pools of residential mortgages, (that is,
cally adjusted to reflect any changes in such loss         pools that are not sold through a government
estimates. The sales gain or loss is the difference        agency program) are permitted to treat such
between the sales price, adjusted for this accrual         transactions as sales only when the selling "bank
of estimated losses, and the recorded amount of            does not retain any significant risk of loss, either
net receivables (gross receivables, including any          directly or indirectly." Recourse is deemed sig-
fees or charges owed by the debtors included               nificant when the maximum contractual exposure

                                                             4. Similar but stricter rules applying to CMOs are pre-
  3. FASB 77, "Reporting by Transferors for Transfers of   sented in FASB Technical Bulletin 85-2, "Collateralized
Receivables with Recourse," was issued in December 1983.   Mortgage Obligations."
October 1989

666 Federal Reserve Bulletin • October 1989

under the recourse provision (or through reten-       the bank are the same as they would have been if
tion of a subordinate interest in the mortgages) at   the assets had not been sold. For example, in the
the time of the transfer is greater than the amount   transfer of a group of high quality assets with a
of the probable loss that the bank has reasonably     "reasonably estimated" loss rate of 1 percent, if
estimated for the transferred mortgages, Under        the transferor assumes the risk of default up to a
such circumstances, the issuing bank has re-          maximum of 10 percent of the total dollar value
tained the entire risk of loss, and the transfer of   of the assets transferred, the transferor in effect
mortgages must be reported as a financing trans-      retains the entire risk inherent in the assets
action.                                               transferred. In addition, to remain viable in the
   The special reporting requirements for trans-      market, the transferor may feel moral pressure to
fers involving residential mortgages were imple-      insulate investors from any losses above the
mented so as not to hamper the development of         amount it is legally committed to meet.
the secondary mortgage markets. When these               Finally, when "sales" can only be made with
reporting requirements were adopted, sales of         recourse, as opposed to selling assets at enough
residential mortgages entailed little or no risk      of a discount to insulate the purchaser of the
retention by the selling institution. The FFIEC is    assets from all but catastrophic losses, banks
now reviewing the general regulatory reporting        may tend to sell only the highest quality assets
treatment of asset sales with recourse. In con-       and keep those of lower quality.
nection with this review, the FFIEC is evaluating        As the asset securitization process has
the need for the special reporting requirements       evolved, the banking agencies have reviewed
for residential mortgage sales and the appropriate    proposed types of asset securitization transac-
way to apply capital requirements to transfers of     tions for compliance with the rules for reporting
residential mortgages with recourse. The FASB         sales of assets on the Call Report. One such
is also reviewing GAAP accounting standards for       transaction approved by the banking agencies did
asset sales with recourse in conjunction with its     not involve recourse to the selling bank but
Financial Instruments Project and expects to          instead used a separate spread account, funded
develop a comprehensive set of accounting stan-       through excess cash flows from the underlying
dards for all financial instruments, including        pool of assets, to absorb credit losses on the
those associated with asset securitization.           transferred loans. The Federal Reserve and the
   Regarding the rationale for the regulatory re-     other banking agencies determined that, for reg-
porting requirements for asset sales with re-         ulatory reporting purposes, sales treatment is
course, the banking regulators historically have      appropriate for such structures because the sell-
considered the existence of any risk that may be      ing bank does not retain the risk of loss.
borne by the seller as the determining factor in
deciding if sales treatment is appropriate. Also,     Interagency Investment Policy Statement
regulators have traditionally been concerned that
loss estimation may be virtually impossible for       On April 20, 1988, the Federal Reserve, along
certain types of loans, such as commercial loans,     with the other federal banking agencies, issued a
construction loans, and loans to developing           policy statement that addressed investment and
countries. Such estimates, however, may be pos-       trading practices of insured commercial banks.
sible for pools of residential mortgages or con-      This policy statement also covered stripped,
sumer loans. Under GAAP, sales treatment is           mortgage-backed securities and residual inter-
prohibited when losses on the transferred loans       ests. Supervisory concerns about these instru-
cannot be estimated.                                  ments arise because of their extreme sensitivity
   In some asset transfers, the transferor, gener-    to interest rates and the resulting price volatility.
ally the originator, may be subject to a partial or   Generally, POs increase in value when interest
limited recourse provision. Even when the terms       rates decline because prepayments of mortgages
of the transfer ostensibly provide only limited       increase, thus shortening their maturities and
recourse, it may, in fact, comprise all losses that   allowing investors to recover their investment
are likely to occur. Thus the potential losses to     sooner than they anticipated. In contrast, IOs
October 1989

                                                       Asset Securitization: A Supervisory Perspective                667

and residuals increase in value when interest                January 1989, assigns assets and the credit equiv-
rates rise because prepayments decline, maturi-              alent amounts of off-balance-sheet items to vari-
ties lengthen, and more interest is collected on             ous broad risk categories, depending on the level
the underlying mortgages. Therefore, banking                 of credit risk associated with that asset. The
organizations sometimes use the purchase of a                aggregate dollar value of the amount in each risk
PO to offset the effect of interest rate movements           category is then multiplied by the risk weight
on the value of mortgage servicing, and the                  associated with it. The resulting weighted values
purchase of an IO or residual to offset interest             from each of the risk categories are added to-
rate risk associated with mortgages and similar              gether, and this sum is the bank's total of risk-
instruments.                                                 weighted assets. An organization's capital (com-
   However, when purchasing an IO, PO, or                    posed of stockholders' equity and certain other
residual, without offsetting hedges, the investor            items) is then divided by its total of risk-weighted
may be speculating on future interest rate move-             assets to calculate its capital ratio.6 The risk-
ments and how those movements will affect the                based capital framework will be phased in begin-
prepayment of the underlying collateral. Further-            ning at the end of 1990 and will be fully effective
more, stripped, mortgage-backed securities that              in 1993.
do not have the guarantee of a government                       The risk-based capital framework has three
agency or government-sponsored agency as to                  main features that will affect the asset securitiza-
principal and interest have an added element of              tion activities of banking organizations. First, the
credit risk. The interagency policy statement on             framework assigns risk weights to loans, asset-
such investments discussed the appropriateness               backed securities, and other assets related to
of them for banks and the prudential measures                securitization. Second, bank holding companies
that a bank should take to protect itself from               that transfer assets with recourse to the seller as
undue risk when it invests in these instruments.5            part of the securitization process will now explic-
   Under guidelines set forth in the policy state-           itly be required to hold capital against their
ment, IOs and POs may be unsuitable for an                   off-balance-sheet credit exposures. Third, bank-
institution's investment portfolio, particularly if          ing organizations that provide credit enhance-
held in significant amounts. Generally, these                ment to asset securitization issues through
guidelines state that banks should not invest in             standby letters of credit or by other means will
stripped, mortgage-backed securities, such as                have to hold capital against the related off-
IOs and POs, unless they have highly sophisti-               balance-sheet credit exposures.
cated and well-managed securities portfolios,                   The risk weights assigned to an asset-backed
mortgage portfolios, or mortgage banking func-               security depend on the issuer and whether the
tions. In such institutions, however, the acquisi-           assets that constitute the collateral pool are mort-
tion of IOs and POs should only be undertaken in             gage related, for example, residential mortgages
conformance with carefully developed and doc-                or pass-through securities. Asset-backed securi-
umented plans prescribing specific positioning               ties issued by a trust or by a single-purpose
limits and control arrangements that have been               corporation and backed by nonmortgage assets
approved by the bank's board of directors.                   will receive a risk weight of 100 percent.
                                                                Securities guaranteed by U.S. government
Risk-Based Capital Provisions Affecting                      agencies and those issued by U.S. government-
Asset Securitization                                         sponsored agencies are assigned risk weights of 0
                                                             and 20 percent respectively because of the low
Capital requirements play an important role in               degree of credit risk, Accordingly, mortgage-
the supervision of banking organizations. The                backed, pass-through securities guaranteed by
new risk-based capital framework, published in
                                                               6. The amounts used for this calculation are taken from a
   5. Press release, "Supervisory Policy Concerning Selec-   banking organization's regulatory reports: the Call Report for
tion of Securities Dealers and Unsuitable Investment Prac-   commercial banks and the Consolidated Financial Statements
tices," Federal Reserve Board, April 20, 1988.               for Bank Holding Companies (F.R. Y-9C).
October 1989

668 Federal Reserve Bulletin • October 1989

(INMA will have a risk weight of 0 percent. In        of the security without undue reliance on any
addition, securities such as participation certifi-   reinvestment income.
cates and CMOs issued by FNMA or FHl.MC                  4. No material reinvestment risk is associated
will have a risk weight of 20 percent.                with any funds awaiting distribution to the hold-
   However, several types of securities issued by     ers of the security.
FNMA and I-HLMC are excluded from the                    Those privately issued, mortgage-backed se-
lower risk weight and slotted in the 100 percent      curities that do not meet the above criteria will
risk weight category. Residual interests (for ex-     receive a risk weight of 100 percent (table 2).
ample. CMC) residuals) and subordinated classes          If the underlying pool of mortgage-related as-
of pass-through securities or CMOs that absorb        sets is composed of more than one type of asset,
more than their pro rata share of loss are as-        then the entire class of mortgage-backed securi-
signed to the 100 percent risk weight category.       ties is assigned to the category of the asset with
Furthermore, all stripped, mortgage-backed se-        the highest risk weight in the pool. If the security
curities, including IOs. POs, and similar instru-     is backed by a pool consisting of U.S. govern-
ments will also receive a risk weight of 100          ment-sponsored agency securities, for example,
percent because of their extreme price volatility.    FHLMC participation certificates, that qualify
The treatment of stripped, mortgage-backed se-        for a risk weight of 20 percent and conventional
curities will be reconsidered when a method to        mortgage loans that qualify for a risk weight of 50
measure interest rate risk is incorporated into the   percent, then the security would receive the 50
risk-based capital guidelines.                        percent risk weight.
   A privately issued, mortgage-backed security          As previously mentioned, bank holding com-
that meets the criteria listed below is considered    panies report their activities in accordance with
either a direct or indirect holding of the underly-   GAAIV which permits asset securiti/ation trans-
ing mortgage-related assets and is assigned to the    actions to be treated as sales when certain crite-
same risk category as those assets (for example,      ria are met, even when there is recourse to the
 U.S. government agency securities, U.S. gov-         seller. With the advent of the risk-based capital
ernment-sponsored agency securities, FHA- and         guidelines, bank holding companies will be ex-
VA-guaranteed mortgages, and conventional             plicitly required to hold capital against the oll-
mortgages). However, under no circumstances           balance-sheet credit exposure arising from the
will a privately issued, mortgage-backed security     contingent liability associated with the recourse
be assigned to the 0 percent risk-weight category.    provisions. 'This exposure is considered a direct
 Therefore, private issues that are backed by         credit substitute that would be converted at 100
CiNMA securities will be assigned to the 20
percent risk-weight category as opposed to the 0
percent category appropriate to the underlying        2. Risk weights accorded missel-hacked securities
CJNMA securities. The criteria that a privately          uiulei the risk-hascd capital guidelines
issued, mortgage-backed security must meet to                                                               Risk weight
                                                              Type of asset-backed securities
be assigned the same risk weight as the underly-                                                             (percent)
ing assets are as follows:
                                                        GNMAs                                                     0
   1. The underlying assets are held by an inde-        FHLMC and FNMA securities                                :o
pendent trustee, and the trustee has a first prior-     Privately issued, mortgage-backed securities
                                                             collatcralized by GNMA, FHI.MC, or
ity, perfected security interest in the underlying           FNMA securities, or by FHA- or
                                                             VA-guaranteed mortgages'                            20
assets on behalf of the holders of the security.        Privately issued, mortgage-bucked securities
                                                             collateralized by one- to four-family
   2. The holder of the security has an undivided            residential properties'                             50
pro rata ownership interest in the underlying           Stripped, mortgage-backed securities,
                                                             residual interests, and subordinated
mortgage assets, or the trust or single purpose              class securities                                    100
                                                        Asset-backed securities collateralized by
entity (or conduit) that issues the security has no          nonmortgage assets                                  100
liabilities unrelated to the issued securities.
                                                         1. I'rivately-issucd, mortgage-backed sccuriiics must incut the cri-
   3. The cash flow from the underlying assets in     teria outlined in the risk-based capital guidelines to lie accorded the
all cases fully meets the cash flow requirements      risk weight of the underlying collatcial.
October 1989

                                                       Asset Securitization: A Supervisory Perspective        669

percent to an on-balance-sheet credit equivalent                • Liquidity and market risks are recognized,
amount for appropriate risk weighting.                       and the organization is not excessively depen-
   Banking organizations that issue standby let-             dent on securitization as a substitute for funding
ters of credit as credit enhancements for asset-             or as a source of income.
backed security issues must hold capital against                • Steps have been taken to minimize the poten-
these contingent liabilities under the risk-based            tial for conflicts of interest due to securitization.
capital guidelines. According to the guidelines,                • Possible sources of structural failure in secu-
financial standby letters of credit are direct credit        ritization transactions are recognized, and the
substitutes, which are converted in their entirety           organization has adopted measures to minimize
to credit equivalent amounts. The credit equiva-             the effect of such failures, should they occur.
lent amounts are then risk weighted according to                • The organization is aware of the legal risks and
the type of counterparty or, if relevant, to any             uncertainty regarding various aspects of securitiza-
guarantee or collateral.                                     tion.
                                                                • Concentrations of exposure in the underlying
 Examination Guidelines                                      asset pools, in the asset-backed securities port-
for Asset Securitization7                                    folio, or in the structural elements of securitiza-
                                                             tion transactions are avoided.
The Federal Reserve is also in the process of                   • All sources of risk are evaluated at the incep-
developing and implementing guidelines to assist             tion of each securitization activity and are mon-
examiners in the on-site review of the involve-              itored on an ongoing basis.
ment of banking organizations in securitization,
both as participants and as investors. The guide-              Moreover, special seminars on asset securiti-
lines provide a more structured framework for                zation have been conducted for senior examin-
assessing the risks associated with the securiti-            ers, and in depth coverage of securitization is-
zation process at banking organizations and for              sues will continue to be part of a regular
determining that they have implemented certain               examiner training program.
prudential policies and procedures in this area. In
accordance with these guidelines, examiners are
to determine that the following conditions are               CONCLUSION
being satisfied:
                                                             In recent years the complexity of asset securiti-
   • Securitization activities are integrated into           zation has increased, and this trend most likely
the overall strategic objectives of the organiza-            will continue. In addition, securitization is in-
tion.                                                        creasing in other countries, and international
   • Sources of credit risk are understood, and prop-        markets for asset-backed securities are expected
erly analyzed and managed, without excessive reli-           to grow rapidly.
ance on credit ratings by outside agencies.                     Asset securitization activities should remain
   • Credit, operational, and other risks are rec-           beneficial to banking organizations when con-
ognized and are addressed through appropriate                ducted in a prudent manner. Banking organiza-
policies, procedures, management reports, and                tions, however, must carefully evaluate the risks
other controls.                                              inherent in new forms of asset securitization and
                                                             maintain appropriate controls, systems, and
                                                             other measures to minimize these risks. The
  7. The Federal Reserve's examination guidelines were       Federal Reserve Board will continue to review
developed by the Asset Securitization Task Force headed by   new asset-backed security structures as they
Franklin D. Dreyer, Senior Vice President, Federal Reserve
Bank of Chicago. The other members of the task force, from   develop to assess the associated risks to banking
the Reserve Banks, are James Barnes, Lawrence Cuy,           organizations and the financial system and to
George Gregorash, Barbara Kavanagh, Mark Levonian, and       factor these developments into its supervisory
Donald Wilson, and from the Board, Roger Cole and the
authors.                                                     process.

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