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October 1989 Asset Securitization: A Supervisory Perspective 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 issues' 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 iiiiina.il 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 Forwards principal ui\d "Passes through" principal and interest interest payments 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.
"Asset Securitization Supervisory Perspective"