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Trading and Capital-Markets Activities Manual

Capital-Markets Activities: Securitization and Secondary-Market Credit Activities
Source: Federal Reserve System 
(The complete Activities Manual (pdf format) can be downloaded from the Federal Reserve's web site)

In recent years, the secondary-market credit activities of many institutions have increased substantially. As the name implies, secondary-market credit activities involve the transformation of traditionally illiquid loans, leases, and other assets into instruments that can be bought and sold in secondary capital markets. It also involves the isolation of credit risk in various types of derivative instruments. Secondary-market credit activities include asset securitizations, loan syndications, loan sales and participations, and credit derivatives, as well as the provision of credit enhancements and liquidity facilities to these transactions. Secondary-market credit activities can enhance both credit availability and bank profitability, but managing the risks of these activities poses increasing challenges: The risks involved, while not new to banking, may be less obvious and more complex than the risks of traditional lending activities. Some secondary-market credit activities involve credit, liquidity, operational, legal, and reputational risks in concentrations and forms that may not be fully recognized by bank management or adequately incorporated in an institution's risk-management systems. In reviewing these activities, supervisors and examiners should assess whether banking organizations fully understand and adequately manage the full range of the risks involved in secondary-market credit activities. 


Banking organizations have long been involved in asset-backed securities (ABS), both as investors and as major participants in the securitization process. In recent years, banks have both increased their participation in the long established residential mortgage-backed securities market and expanded their activities in securitizing other types of assets, such as credit card receivables, automobile loans, boat loans, commercial real estate loans, student loans, nonperforming loans, and lease receivables. 

While the objectives of securitization may vary from institution to institution, several benefits can be derived from securitized transactions. First, the sale of assets may reduce regulatory costs by reducing both risk-based capital requirements and the reserves held against the deposits used to fund the sold assets. Second, securitization provides originators with an additional source of funding or liquidity since the process of securitization converts an illiquid asset into a security with greater marketability. Securitized issues often require a credit enhancement, which results in a higher credit rating than what would normally be obtainable by the institution itself. Consequently, securitized issues may provide the institution with a cheaper form of funding. Third, securitization may be used to reduce interest-rate risk by improving the institution's asset/liability mix. This is especially true if the institution has a large investment in fixed-rate, low-yield assets. Finally, the ability to sell these securities worldwide diversifies the institution's funding base, which reduces the bank's dependence on local economies. 

While securitization activities can enhance both credit availability and bank profitability, the risks of these activities must be known and managed. Asset securitization may involve credit, liquidity, operational, legal, and reputational risks in concentrations and forms that may not be fully recognized by bank management or adequately incorporated in an institution's risk-management systems. Accordingly, banking institutions should ensure that their overall risk-management process explicitly incorporates the full range of the risks involved in their securitization activities. 

In reviewing asset securitization activities, examiners should assess whether banking organizations fully understand and adequately manage the full range of the risks involved in their activities. Specifically, supervisors and examiners should determine whether institutions are recognizing the risks of securitization activities by (1) adequately identifying, quantifying, and monitoring these risks; (2) clearly communicating the extent and depth of risks in reports to senior management and the board of directors and in regulatory reports; (3) conducting ongoing stress testing to identify potential losses and liquidity needs under adverse circumstances; and (4) setting adequate minimum internal standards for allowances or liabilities for losses, capital, and contingency funding. Incorporating asset securitization activities into banking organizations' risk-management systems and internal capital-adequacy allocations is particularly important; current regulatory capital rules may not fully capture the economic substance of the risk exposures arising from many of these activities. 

An institution's failure to adequately understand the risks inherent in its secondary-market credit activities and to incorporate risks into its risk-management systems and internal capital allocations may constitute an unsafe and unsound banking practice. Accordingly, for those institutions involved in asset securitization or providing credit enhancements in connection with loan sales and securitization, examiners should assess whether the institutions' systems and processes adequately identify, measure, monitor, and control all of the risks involved in the secondary-market credit activities.1 

Securitization Process 

In its simplest form, asset securitization is the transformation of generally illiquid assets into securities that can be traded in the capital markets. The asset securitization process begins with the segregation of loans or leases into pools that are relatively homogeneous with respect to their cash-flow characteristics and risk pro-files, including both credit and market risks. These pools of assets are then transferred to a bankruptcy-remote entity such as a grantor trust or special-purpose corporation that issues securities or ownership interests in the cash flows of the underlying collateral. These ABS may take the form of debt, certificates of beneficial ownership, or other instruments. The issuer is typically protected from bankruptcy by various structural and legal arrangements. Normally, the sponsor that establishes the issuer is the originator or provider of the underlying assets. 

Each issue of ABS has a servicer that is responsible for collecting interest and principal payments on the loans or leases in the underlying pool of assets and for transmitting these funds to investors (or a trustee representing them). A trustee is responsible for monitoring the activities of the servicer to ensure that it properly fulfills its role. A guarantor may also be involved to ensure that principal and interest payments on the securities will be received by investors on a timely basis, even if the servicer does not collect these payments from the obligors of the underlying assets. Many issues of mortgage-backed securities are either guaranteed directly by the Government National Mortgage Association (GNMA or GinnieMae), which is backed by the full faith and credit of the U.S. government, or by the Federal National Mortgage Association (FNMA or FannieMae), or the Federal Home Loan Mortgage Corporation (FHLMCor FreddieMac), which are government-sponsored agencies that are perceived by the credit markets to have the implicit support of the federal government. Privately issued, mortgage-backed securities and other types of ABS generally depend on some form of credit enhancement provided by the originator or third party to insulate the investor from a portion of or all credit losses. Usually, the amount of the credit enhancement is based on several multiples of the historical losses experienced on the particular asset backing the security. 

The structure of an asset-backed security and the terms of the investors' interest in the collateral can vary widely depending on the type of collateral, the desires of investors, and the use of credit enhancements. Often ABS are structured to re-allocate the risks entailed in the underlying collateral (particularly credit risk) into security tranches that match the desires of investors. For example, senior-subordinated security structures give holders of senior tranches greater credit-risk protection (albeit at lower yields) than holders of subordinated tranches. Under this structure, at least two classes of asset-backed securities, a senior class and a junior or subordinated class, are issued in connection with the same pool of collateral. The senior class is structured so that it has a priority claim on the cash flows from the underlying pool of assets. The subordinated class must absorb credit losses on the collateral before losses can be charged to the senior portion. Because the senior class has this priority claim, cash flows from the underlying pool of assets must first satisfy the requirements of the senior class. Only after these requirements have been met will the cash flows be directed to service the subordinated class. 

1. The Federal Reserve System has developed a three-volume set that contains educational material concerning the process of asset securitization and examination guidelines (see SR-90-16). The volumes are (1) An Introduction to Asset Securitization, (2) Accounting Issues Relating to Asset Securitization, and (3) Examination Guidelines for Asset Securitization. 

Credit Enhancements 

ABS can use various forms of credit enhancements to transform the risk-return profile of underlying collateral. These include third-party credit enhancements, recourse provisions, over-collateralization, and various covenants and indentures. Third-party credit enhancements include standby letters of credit, collateral or pool insurance, or surety bonds from third parties. Recourse provisions are guarantees that require the originator to cover any losses up to a contractually agreed-on amount. One type of recourse provision, usually seen in securities backed by credit card receivables, is the ''spread account.'' This account is actually an escrow account, the funds of which are derived from a portion of the spread between the interest earned on the assets in the underlying pool of collateral and the lower interest paid on securities issued by the trust. The amounts that accumulate in this escrow account are used to cover credit losses in the underlying asset pool, up to several multiples of historical losses on the particular asset collateralizing the securities. 

Over-collateralization is another form of credit enhancement that covers a predetermined amount of potential credit losses. When the value of the underlying assets exceeds the face value of the securities, the securities are said to be over-collateralized. A similar form of credit enhancement is the cash-collateral account, which is established when a third party deposits cash into a pledged account. The use of cash-collateral accounts, which are considered to be loans, grew as the number of highly rated banks and other credit enhancers declined in the early 1990s. Cash-collateral accounts eliminate ''event risk,'' or the risk that the credit enhancer will have its credit rating downgraded or that it will not be able to fulfill its financial obligation to absorb losses. Thus, credit protection is provided to the investors of a securitization. 

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

Types of Asset-Backed Securities 

The many different varieties of asset-backed securities are often customized to the terms and characteristics of the underlying collateral. Most common are securities collateralized by (1) revolving credit lines such as card receivables, (2) closed-end installment loans such as automobile and student loans, and (3) lease receivables. The instrument profiles on asset-backed securities and mortgage-backed securities in this manual (sections 4105.1 and 4110.1, respectively) present specific information on the nature and structure of various types of securitized assets. 

In addition to specific ABS, other types of financial instruments may arise as a result of asset securitization, such as loan-servicing rights, excess-servicing-fee receivables, and ABS residuals. Loan-servicing rights are created in one of two ways.2 Servicing rights can be purchased outright from other institutions or can be created when organizations (1) purchase or originate loans or (2) sell or securitize these loans and retain the right to act as servicers for the pools of loans. The capitalized servicing asset is treated as an identified intangible asset for purposes of regulatory capital. Excess-servicing-fee receivables generally arise when the present value of any additional cash flows from the underlying assets that a servicer expects to receive exceeds standard servicing fees. ABS residuals (sometimes referred to as ''residuals'' or ''residual interests'') represent claims on any cash flows that remain after all obligations to investors and any related expenses have been met. The excess cash flows may arise as a result of over-collateralization or from reinvestment income. Residuals can be retained by sponsors or purchased by investors in the form of securities. 

Securitization of Commercial Paper 

Bank involvement in the securitization of commercial paper has increased significantly over time. However, asset-backed commercial paper programs differ from other methods of securitization. One difference is that more than one type of asset may be included in the receivables pool. Moreover, in certain cases, the cash flow from the receivables pool may not necessarily match the payments to investors because the maturity of the underlying asset pool does not always parallel the maturity of the structure of the commercial paper. Consequently, when the paper matures, it is usually rolled over or funded by another issue. In certain circumstances, a maEagle Tradersg issue of commercial paper cannot be rolled over. To address this problem, many banks have established back-up liquidity facilities. Certain banks have classified these back-up facilities as pure liquidity facilities, despite the credit-enhancement element present in them. As a result, the risks associated with these facilities are incorrectly assessed. In these cases, the back-up liquidity facilities are more similar to direct credit substitutes than to loan commitments. 

2. In May 1995, the Financial Accounting Standards Board (FASB) issued its Statement of Financial Accounting Standards No. 122 (SFAS 122), ''Accounting for Mortgage Servicing Rights.'' SFAS 122 eliminated the accounting distinctions between originated servicing rights, which were not allowed to be recognized on the balance sheet, and purchased servicing rights, which were capitalized as a balance-sheet asset. See section 2120.1, ''Accounting.'' 


While banking organizations that engage in securitization activities and invest in ABS accrue clear benefits, these activities can potentially increase the overall risk profile of the banking organization. For the most part, the types of risks that financial institutions encounter in the securitization process are identical to those faced in traditional lending transactions, including credit risk, concentration risk, interest-rate risk (including prepayment risk), operational risk, liquidity risk, moral-recourse risk, and funding risk. However, since the securitization process separates the traditional lending function into several limited roles, such as originator, servicer, credit enhancer, trustee, and investor, the types of risks that a bank will encounter will differ depending on the role it assumes. Senior management and the board of directors should have the requisite knowledge of the effects of securitization on the banking organization's risk profile and should be fully aware of the accounting, legal, and risk-based capital implications of this activity. Banking organizations need to fully and accurately distinguish and measure the risks that are transferred versus those retained, and they must adequately manage the retained portion. Banking organizations engaging in securitization activities must have appropriate back- and front-office staffing; internal and external accounting and legal support; audit or independent-review coverage; information systems capacity; and oversight mechanisms to execute, record, and administer these transactions. 

Risks to Investors 

Investors in ABS will be exposed to varying degrees of credit risk, just as they are in direct investments in the underlying assets. Credit risk is the risk that obligors will default on principal and interest payments. ABS investors are also subject to the risk that the various parties in the securitization structure, for example, the servicer or trustee, will be unable to fulfill its contractual obligations. Moreover, investors may be susceptible to concentrations of risks across various asset-backed security issues through overexposure to an organization performing various roles in the securitization process or as a result of geographic concentrations within the pool of assets providing the cash flows for an individual issue. Since the secondary markets for certain ABS are limited, investors may encounter greater than anticipated difficulties when seeking to sell their securities (liquidity risk). Furthermore, certain derivative instruments, such as stripped asset-backed securities and residuals, may be extremely sensitive to interest rates and exhibit a high degree of price volatility. Therefore, derivative instruments may dramatically affect the risk exposure of investors unless these instruments are used in a properly structured hedging strategy. Examiner guidance in section 3000.1, ''Investment Securities and End-User Activities,'' is directly applicable to ABS held as investments. 

Risks to Issuers and Institutions Providing Credit Enhancements 

Banking organizations that issue ABS may be subject to pressures to sell only their best assets, thus reducing the quality of their loan portfolios. On the other hand, some banking organizations may feel pressured to relax their credit standards because they can sell assets with higher risk than they would normally want to retain for their own portfolios. To protect their names in the market, issuers may also face pressures to provide ''moral recourse'' by repurchasing securities backed by loans or leases they have originated that have deteriorated and become nonperforming. Funding risk may also be a problem for issuers when market aberrations do not permit asset-backed securities that are in the securitization pipeline to be issued. 

Credit Risks 

The partial, first-loss recourse obligations an institution retains when selling assets, and the extension of partial credit enhancements (for example, 10 percent letters of credit) in connection with asset securitization, can be sources of concentrated credit risk. Institutions are exposed to the full amount of expected losses on the protected assets. For instance, the credit risk associated with whole loans or pools of assets that are sold to secondary-market investors can often be concentrated within the partial, first-loss recourse obligations retained by the banking organizations selling and securitizing the assets. In these situations, even though institutions may have reduced their exposure to catastrophic loss on the assets sold, they generally retain the same credit-risk exposure as if they continued to hold the assets on their balance sheets. 

In addition to recourse obligations, institutions assume concentrated credit risk through the extension of partial direct credit substitutes, such as through the purchase (or retention) of subordinated interests in their own asset securitizations or through the extension of letters of credit. For example, banking organizations that sponsor certain asset-backed commercial paper programs, or so-called ''remote origination'' conduits, can be exposed to high degrees of credit risk even though their notional exposure may seem minimal. This type of remote origination conduit lends directly to corporate customers that are referred to it by the sponsoring banking organization that used to lend directly to these same borrowers. The conduit funds this lending activity by issuing commercial paper that, in turn, the sponsoring banking organization guarantees. The net result is that the sponsoring institution's credit-risk exposure through this guarantee is about the same as it would have been if it had made the loans directly and held them on its books. However, this is an off-balance-sheet transaction, and its associated risks may not be fully reflected in the institution's risk-management system. 

Furthermore, banking organizations that extend liquidity facilities to securitized transactions, particularly to asset-backed commercial paper programs, may be exposed to high degrees of credit risk subtly embedded within a facility's provisions. Liquidity facilities are commitments to extend short-term credit to cover temporary shortfalls in cash flow. While all commitments embody some degree of credit risk, certain commitments extended to asset-backed commercial paper programs to provide liquidity may subject the extending institution to the credit risk of the underlying asset pool (often trade receivables) or a specific company using the program for funding. Often the stated purpose of liquidity facilities is to provide funds to the program to retire maEagle Tradersg commercial paper when a mismatch occurs in the maturities of the underlying receivables and the commercial paper, or when a disruption occurs in the commercial paper market. However, depending on the provisions of the facility-such as whether the facility covers dilution of the underlying receivable pool-credit risk can be shifted from the program's explicit credit enhancements to the liquidity facility.3 Such provisions may enable certain programs to fund riskier assets and maintain the credit rating on the program's commercial paper without increasing the program's credit-enhancement levels. 

The structure of various securitization transactions can also result in an institution's retaining the underlying credit risk in a sold pool of assets. Examples of this contingent credit-risk retention include credit card securitization, in which the securitizing organization explicitly sells the credit card receivables to a master trust, but, in substance, retains the majority of the economic risk of loss associated with the assets because of the credit protection provided to investors by the excess yield, spread accounts, and structural provisions of the securitization. Excess yield provides the first level of credit protection that can be drawn on to cover cash shortfalls between (1) the principal and coupon owed to investors and (2) the investors' pro rata share of the master trust's net cash flows. The excess yield is equal to the difference between the overall yield on the underlying credit card portfolio and the master trust's operating expenses.4 The second level of credit protection is provided by the spread account, which is essentially a reserve initially funded from the excess yield. 

In addition, the structural provisions of credit card securitization generally provide credit protection to investors through the triggering of early amortization events. Such an event usually is triggered when the underlying pool of credit card receivables deteriorates beyond a certain point and requires that the outstanding credit card securities begin amortizing early to pay off investors before the prior credit enhancements are exhausted. The early amortization accelerates the redemption of principal (pay-down) on the security, and the credit card accounts that were assigned to the master credit-card trust return to the securitizing institution more quickly than had originally been anticipated. Thus, the institution is exposed to liquidity pressures and any further credit losses on the returned accounts. 

3. Dilution essentially occurs when the receivables in the underlying asset pool-before collection-are no longer viable financial obligations of the customer. For example, dilution can arise from returns of consumer goods or unsold merchandise by retailers to manufacturers or distributors. 
4. The monthly excess yield is the difference between the overall yield on the underlying credit card portfolio and the master trust's operating expenses. It is calculated by subtracting from the gross portfolio yield the (1) coupon paid to investors, (2) charge-offs for that month, and (3) servicing fee, usually 200 basis points paid to the banking organization sponsoring the securitization. 

Reputational Risks 

The securitization activities of many institutions may expose them to significant reputational risks. Often, banking organizations that sponsor the issuance of asset-backed securities act as a servicer, administrator, or liquidity provider in the securitization transaction. These institutions must be aware of the potential losses and risk exposure associated with reputational risk from securitization activities. The securitization of assets whose performance has deteriorated may result in a negative market reaction that could increase the spreads on an institution's subsequent issuances. To avoid a possible increase in their funding costs, institutions have supported their securitization transactions by improving the performance of the securitized asset pool. This has been accomplished, for example, by selling discounted receivables or adding higher quality assets to the securitized asset pool. Thus, an institution's voluntary support of its securitization to protect its reputation can adversely affect the sponsoring or issuing organization's earnings and capital. 

Liquidity Risks 

The existence of recourse provisions in asset sales, the extension of liquidity facilities to securitization programs, and the early amortization triggers of certain asset securitization transactions can involve significant liquidity risk to institutions engaged in these secondary-market credit activities. Institutions should ensure that their liquidity contingency plans fully incorporate the potential risk posed by their secondary-market credit activities. When new asset-backed securities are issued, the issuing banking organization should determine their potential effect on its liquidity at the inception of each transaction and throughout the life of the securities to better ascertain its future funding needs. 

An institution's contingency plans should consider the need to obtain replacement funding and specify possible alternative funding sources, in the event of the amortization of outstanding asset-backed securities. Replacement funding is particularly important for securitization with revolving receivables, such as credit cards, in which an early amortization of the asset-backed securities could unexpectedly return the outstanding balances of the securitized accounts to the issuing institution's balance sheet. An early amortization of a banking organization's asset-backed securities could impede its ability to fund itself-either through re-issuance or other borrowings-since the institution's reputation with investors and lenders may be adversely affected. 

Servicer-Specific Risks 

Banking organizations that service securitization issues must ensure that their policies, operations, and systems will not permit breakdowns that may lead to defaults. Substantial fee income can be realized by acting as a servicer. An institution already has a fixed investment in its servicing systems; achieving economies of scale relating to that investment is in its best interest. The danger, though, lies in overloading the system's capacity, thereby creating enormous out-of-balance positions and cost overruns. Servicing problems may precipitate a technical default, which in turn could lead to the premature redemption of the security. In addition, expected collection costs could exceed fee income. (For further guidance, see section 2040.3, ''Loan Portfolio Management,'' examination procedure 14b, of the Commercial Bank Examination Manual.) 


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