Asset-Backed Securitization Section 221

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CHAPTER: Asset Quality

SECTION: Asset-Backed Securitization Section 221

INTRODUCTION

Asset securitization is the process by which loans or For investors, asset-backed securities offer a collat- other credit exposures are pooled and reconstituted eralized security that generally has a good return into securities, with one or more classes or positions with little credit risk, improved marketability over that may be sold. It generally involves a multi-step purchased loan pools, and assets that are underwrit- process in which an institution transfers illiquid on- ten and serviced by an experienced lender. balance-sheet assets, such as loans, leases, or other Borrowers also benefit because securitization assets, to a special purpose wholly owned subsidi- makes more credit available at terms that are more ary, which, in turn, transfers them to a trust. The favorable and at a lower cost than if the loans were trust then issues securities, certificates, notes, or not securitized. interests to investors. While the benefits can be substantial, the risks, Through securitization, the trust/issuer redistributes which exist throughout all phases of the securitiza- the credit risk of an asset pool among a tiered struc- tion process and continue while the securities ture of securities, with the most senior security remain outstanding, can also be substantial. This having first priority on the cash flows generated by Section addresses those risks. the asset pool and the most junior position, the last or lowest priority. The most junior position in a Primary Risks securitization structure is often referred to as the residual interest. Typically, the institution transfer- Managing the risks of securitization activities can ring the assets holds some of the highest risk pose a greater challenge to institutions than manag- positions associated with the securitization transac- ing traditional lending activities. Securitization risks tion, including the residual interest. can be both less obvious and more complex. Securi- tization, like traditional lending, can involve credit Securitization can be an important component of an risk, concentration risk, interest rate risk (including institution’s overall business strategy. An increas- prepayment risk), operational risk, liquidity risk, ing number of institutions are using asset-backed reputation risk, and funding risk. securitization to access new and diverse funding sources, manage concentrations, and improve fi- Moreover, these risks may be in concentrations and nancial performance ratios, while, at the same time, forms unfamiliar to a traditional lender. The types effectively serving the needs of their borrowers. of risks that an institution faces can vary substan- Assets most often securitized by savings associa- tially, based on its role(s) in the securitization tions include credit card and auto receivables, process and the nature of its activities, including the residential first mortgages, and home equity loans. transaction structure(s), activity level, volume of transactions, the risk profile of securitized assets, Primary Benefits and any increased concentrations (by product, funding sources, or otherwise), and the amount and type Securitization can be an effective financial interme- of concentrated credit risk retained by the institu- diation and risk management tool. For the tion. originator/seller in a securitization, the benefits include the freeing of capital to allow additional The Securitization Cash Flow Waterfall lending, the ability to retain servicing, which provides an income source, the ability to produce a Unlike loan participations, which share in credit return on off-balance-sheet assets with reduced risk proportionately, a securitization can create a credit or liquidity risks, and lower capital costs. complex structure of securities and interests with multiple levels of risk and returns. The cash flow (interest and principal payments) from the pool of

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transferred assets supports the payments to all the nized and reflected in risk management systems and securities and interests in a securitization. Gener- internal capital adequacy allocations. ally, the most senior security is paid in full first, then the next most senior, and on down the tiered During the examination, you should determine structure. The most junior security, typically the whether the institution fully recognizes the risks of residual interest, is paid last and only if sufficient securitization. Institution management should per- funds remain after all the more senior claims are form all of the following: paid in full. It is the nature and properties of this cash flow “waterfall” that is at the heart of securiti- · Identify, quantify, and monitor all risks. zation risk analysis. · Communicate regularly the extent and signifi- cance of these risks in reports to senior The residual interest, usually retained by the thrift, management and the board of directors. is not only the riskiest of all the positions but also the one most difficult to value. Because market · Stress test the securitization programs to iden- prices are not usually available for retained inter- tify the extent of its loss exposure and possible ests, institutions often use models to estimate their liquidity disruptions. values. The institution’s use of a valuation model · Maintain adequate allowances for losses, carry- introduces its own risks. The model itself may be ing values of assets retained, sufficient capital flawed, the assumptions used in it may be unrealis- levels, and contingency funding sources. tic, or the sensitivity of the results to changes in loss estimates, prepayment speeds, or discount rates You should be concerned when, among other con- may be underestimated. An institution’s vulnerabil- siderations, an institution’s management does not ity to “model risk” can be severe. fully understand the risks inherent in its securitization activities or fails to fully reflect such risks in Examination Approach its management systems and internal capital allocations. Such circumstances constitute an unsafe and This section provides guidance on assessing the unsound practice. Consistent with the Interagency risks created by an institution’s securitization ac- Guidance on Asset Securitization contained in Ap- tivities and evaluating how well the institution pendix A, institutions that lack effective risk manages them. It focuses primarily on the role of management programs or engage in practices that the institution as financial intermediary, that is, as present safety and soundness concerns will be sub- loan originator, packager, servicer, credit enhancer, ject to more frequent supervisory reviews, more underwriter, or trustee, rather than as an investor in stringent capital requirements, or other supervisory securities. responses. The OTS Regional Director could require a downgrade of an institution’s supervisory This section describes: (CAMELS) rating under such circumstances. · The characteristics of a sound asset securitiza- THE SECURITIZATION PROCESS tion function and prudent risk management practices. The securitization process redistributes risk by · Relevant accounting treatment, which can af- breaking up the traditional role of the lender into a fect an institution’s reported measures of number of specialized roles: originator, servicer, profitability, reserve requirements, and capital. credit enhancer, underwriter, trustee, and investor. Depository institutions may be involved in several · Supervisory considerations that should be in- of these roles. They often specialize in a particular corporated in any assessment of the risks that role or roles to take advantage of their specific ex- securitization activities present to an institution. pertise or economies of scale. The types and levels of risk to which a particular institution is exposed The institution’s board of directors and manage- will depend on its role in, and management of, the ment are ultimately responsible for having policies securitization process. in place that ensure that the economic substance of all the institution’s risk exposures is fully recog-

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In scoping the examination, you should review the contractually bound by the terms of the servic- business plan to obtain an understanding of the in- ing agreement. stitution’s role(s) and overall activities. You should · Phase 3: The QSPE/issuer, with assistance also review the relationship of the institution with from an underwriter, structures the security(ies) its holding company and affiliates, as they may be and obtains necessary credit enhancements to involved in the securitization process. Their in- improve the rating assigned by a rating agency volvement could include holding interests, providing and the marketability of the securities to be is- staff and resources in support of the securitization sued to the public. program, as well as potentially providing credit enhancements in subtle forms. You should read the · Phase 4: The QSPE/issuer sells interests in the various agreements associated with each securitiza- transferred asset pool(s) in the form of securi- tion. As discussed later in this section, these include ties, notes, or certificates. Note: Institutions can the pooling and servicing agreement, as well as any use their corporate debt (12 CFR § 560.40) or series supplement, which provide explicit detail on pass-though (12 CFR § 560.32) investment au- the structure and design of the particular asset- thority to invest in certain asset-backed backed security and responsibilities of each party to securities. the transaction. Phase 1: Pool/Segregate Assets for Transfer The primary difference between whole loan sales or participations and securitized pools of loans is the This phase involves the borrowers and trans- structuring process. Before loan pools can be con- feror/originator. The transferor originates and often verted into securities, they are typically restructured services the loans that generate the cash flows sup- to modify the nature of the risks and returns to the porting the securitization structure. The borrowers investors. Structuring includes the isolation and make payments on the underlying loans. Therefore, distribution of credit risk, usually through credit the performance of the asset-backed security is enhancement techniques, and use of trusts and spe- largely dependent on the ability of the borrower to cial purpose entities to address ownership issues repay the loan consistent with the terms of the loan and to manage cash flows generated by the loan agreement. Even though the loans are transferred, pools. the originator maintains the customer relationship with the borrowers. Generally, the structure of a transaction is governed by the terms of the pooling and servicing agree- Asset Selection ment, and for master trusts, each series supplement. The pooling and servicing agreement is the primary Securitization involves the conveyance of loans to contractual document between the seller/servicer an SPE and ultimately to the QSPE. For revolving and the trustee. This agreement documents the type assets, this conveyance includes the amount of terms of the asset transfer and the responsibilities of receivables and certain designated accounts on a the seller/servicer. specific cutoff date, plus the option for the QSPE to purchase new receivables that arise from those des- The securitization process consists of four primary ignated accounts subsequent to the cutoff date. The phases, which occur virtually simultaneously: accounts are subject to eligibility criteria and specific representations and warranties of the · Phase 1: The institution/transferor segregates transferor. assets for transfer to a special purpose entity (SPE), a bankruptcy-remote, wholly owned The transferor designates which accounts will be subsidiary. transferred. The selection is carried out with an eye · Phase 2: The SPE then transfers the assets re- towards creating a portfolio whose performance is ceived from the institution to a Qualifying not only predictable but also consistent with the Special Purpose Entity (QSPE). A servicer is target qualities of the desired security. Other selec- designated for the transferred assets, who is tion criteria might include geographic location,

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maturity date, size of credit line, or age of the ac- and home equity lines of credit, require issuers to count relationship. modify the structures used to securitize the assets. For example, a static portfolio of credit card receiv- Account selection can either be random, to create ables typically has a life of between five and ten selections that are representative of the total portfo- months. Because such a life is too short for efficient lio held by the institution, or inclusive, so that all security issuance, securities backed by revolving qualifying receivables are transferred. In random loans are structured in a manner to facilitate selections, the transferor determines how many ac- management of the cash flows. Rather than counts are needed to meet the target value of the distributing principal and interest to investors as security. It then selects accounts randomly (for ex- received, the securities distribute cash flow in ample, every sixth account is selected from the stages: a revolving phase, followed by an amorti- eligible universe). zation phase. During the revolving period, only interest is paid. Principal payments are reinvested in Pooling by Asset Type additional receivables as, for example, customers use their credit card or take additional draws on The collateral supporting a securitization often de- their home equity lines. At the end of a revolving fines its structure. For example, installment loans period, the amortization phase begins, where dictate a substantially different structure than re- principal payments are made to investors along with volving lines of credit. Installment loans, such as interest payments. Because the principal balances those made for the purchase of automobiles, trucks, are repaid over a short time, the life of the security and recreational vehicles, have defined amortization is largely determined by the revolving period. schedules and fixed maturity dates. Revolving loans, such as credit cards and home equity lines of Borrower Characteristics credit, have no specific amortization schedules or final maturity date. Revolving loans can be ex- Because cash flows are more predictable with ho- tended and repaid repeatedly over time, more or less mogenous asset pools, institutions will further at the discretion of the borrower. group loans by considering other characteristics, for example, borrower credit quality. Installment Loan Pools/Transactions. Institutions often assign borrowers a letter grade A typical installment contract asset-backed secu- based on their credit quality. At the top of the rating rity, which in some ways resembles a mortgage scale, ‘A’ quality borrowers have relatively pristine pass-through security, provides investors with an credit histories; at the bottom of the scale, ‘D’ qual- undivided interest in a specific pool of assets sup- ity borrowers usually have severely blemished porting the securitization. credit histories. The categories are by no means rigid. In fact, credit evaluation problems exist be- The repayment terms for most installment contract cause one originator’s ‘A-’ borrower may be asset-backed securities call for investors to receive another originator’s ‘B’ or ‘C’ borrower. Neverthe- a portion of all the interest and principal received less, the terms ‘A’, ‘Alt-A’, and ‘B/C’ paper are by the trust each month. The trust certificate usu- widely used. ally stipulates that investors will receive a stated monthly interest payment on the outstanding bal- Segmenting borrowers by grade allows outside par- ance of their certificates. The amount of principal ties such as rating agencies to compare performance included in each payment depends on the amortiza- of a specific company or underwriter more readily tion of the underlying collateral, plus any with that of its peer group. prepayments that are received during the month. Prepayments shorten the average life of the issue. Phase 2: Creation of a Securitization Vehicle

Revolving Asset Pools/Transactions. The creation of a securitization program involves two steps: (1) the creation of a SPE by the institu- The typically short lives of receivables associated tion, and (2) the formation of a QSPE by the with revolving loan products, such as credit cards

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subordinate organization, which actually issues the · Replaces the servicer if it fails to perform in asset-backed securities. accordance with required terms. · Receives, throughout the life of the transaction, Step 1: Creating a SPE periodic financial information from the originator and servicer delineating, among other An institution, as the originator/transferor, estab- things, amounts collected, amounts charged off, lishes a wholly owned subordinate organization to and collateral values. serve as the SPE. The institution transfers the assets to the SPE. On the institution’s books, the · Reviews financial information received to en- transfer is treated as a sale or a financing in accor- sure that the underlying assets produce dance with GAAP as detailed in FASB 140, adequate cash flow to service the securities. Securitization Accounting. (Refer to “Accounting · Declares, when necessary, a default or an early Treatment” in this section.) Generally, a SPE is amortization triggering event. designed so that the possibility that the institution (or its creditors) could reclaim the assets is remote. If problems develop in the transaction, the trustee For example, any residual cash flow due to the SPE focuses on the obligations and performance of all is pledged back to the QSPE. Then, if OTS closes parties associated with the security, particularly the the institution, there are no assets in the SPE for the servicer and credit enhancer. creditors to attach because a counterparty pledge agreement exists between the SPE and QSPE. Servicing Transferred Assets

Step 2: Forming a QSPE The trustee selects a servicer to collect interest and principal payments on the loans or leases in the The SPE transfers the assets to the QSPE, which pool of transferred assets and then transmit these then issues the asset-backed securities, completing funds to investors (or a trustee representing them). the securitization process. The cash raised by the sale of securities is used to compensate the SPE and The originator/transferor usually continues to ser- institution for the transferred assets. vice the portfolio after securitization. (The only assets with an active and deep secondary market for The senior securities issued by the QSPE typically servicing contracts are mortgages.) The servicer have a sufficient increase in credit and yield protec- typically retains a fixed percentage of the out- tion provided by a subordinated retained beneficial standing loan balances as a servicing fee. interest or other means to merit the high credit rating sought by investors. The responsibilities of the institution as the servicer for a securitized portfolio include all of the follow- Role of the Trustee ing:

The QSPE generally designates a third party trustee · Customer service and payment processing for to administer, for a fee, the trust that holds the un- borrowers. derlying assets supporting the securitization. Acting in a fiduciary capacity, the trustee is primarily con- · Collection actions in accordance with the pool- cerned with preserving the rights of the investor. ing and servicing agreement. The responsibilities of the trustee will vary for each · Default management and collateral liquidation. issue and are delineated in a separate trust agreement. Generally, the trustee: · Providing administrative support for the benefit of the trust that is duty bound to protect the in- · Oversees the disbursement of cash flows as terests of investors. prescribed by the indenture or pooling and ser- · Preparing monthly information reports. vicing agreement. · Remitting collection of payments to the trust. · Monitors compliance with appropriate covenants by the parties to the agreement.

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· Providing the trustee with monthly instructions under the Internal Revenue Code and does not pay for the disposition of trust assets. federal income tax. Instead, each certificate holder, including the special purpose entity, must sepa- The servicer usually prepares its reports on a rately take into account an allocated share of monthly basis, with specific format requirements income, gains, losses, deductions, and the credits of for each performance and administrative report. the trust. Like a grantor trust, the owner trust is The servicer distributes the reports to the investors, expressly limited in its activities by its charter, al- the trustee, the rating agencies, and the credit en- though owner trusts are typically used when the hancer. cash flows of the assets must be managed to create bond like securities. Unlike a grantor trust, the Phase 3: The Issuer Structure owner trust can issue securities in multiple series with different maturities, interest rates, and cash The QSPE is typically structured as a trust, in one flow priorities. of the following forms: Revolving Asset Trust · Grantor trust. · Owner trust. This trust may be structured either as a stand-alone or master trust. The stand-alone trust is simply a · Revolving asset trust. single group of accounts whose receivables are sold to a trust and used as collateral for a single secu- Each type of trust typically issues different types of rity, although there may be several classes within securities. In choosing a trust structure, the thrift that security. When the issuer intends to issue an- institution seeks to ensure that the transaction insu- other security, it simply designates a new group of lates the assets from the reach of the thrift and its accounts and sells their receivables to a separate creditors, and that the issuer, securitization vehicle, trust. As the desire for additional flexibility, effi- and investors receive a favorable tax treatment. ciency, and uniformity of collateral performance for various series issued by the same issuer increased, Grantor Trust the stand-alone structure evolved into the master trust structure. In a grantor trust, the certificate holders (investors) are treated as beneficial owners of the assets sold. Master trusts allow an issuer to sell a number of The net income from the trust is taxed on a pass- securities and series at different times from the through basis as if the certificate holders directly same trust. All of the securities rely on the same own the receivables. To qualify as a grantor trust, pool of receivables as collateral. In a master trust, the structure of the deal must be passive – that is, each certificate of each series represents an undi- the trust cannot engage in profitable activities for vided interest in all of the receivables in the trust. the investors, and there cannot be multiple classes The structure provides the issuer with much more of interest. Grantor trusts are commonly used when flexibility. The issuer can issue a new series from a the underlying assets are installment loans whose master trust at a lower cost and with less effort than interest and principal payments are reasonably pre- creating a new trust for every issue. In addition, the dictable and fit the desired security structure. credit evaluation of each series in a master trust is much easier since the pool of receivables will be Owner Trust larger and less susceptible to seasonal or demo- graphic concentrations. Credit cards, home equity In an owner trust, the assets are usually subject to a lines of credit, and other revolving assets are usu- lien of indenture through which notes are issued. ally packaged in these structures. A revolving asset The beneficial ownership of the trust’s assets is trust is treated as a security arrangement and is ig- represented by certificates, which may be sold or nored for tax purposes. retained by the issuer. An owner trust, properly structured, will be treated as a partnership under the Internal Revenue Code of 1986. A partnership like a grantor trust is effectively a pass-through entity

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Credit Enhancements Surety bonds. Third party surety bond providers, usually triple-A rated mono-line insurance compa- Credit enhancements protect investors when the nies, generally provide a guarantee for 100 percent cash flows from the underlying assets are insuffi- of the principal and interest payments. cient to pay the interest and principal for a security in a timely manner. An issuer uses credit enhance- Internal Credit Enhancements ments to improve a security’s credit rating, and, therefore, its pricing and marketability. Among internal enhancements, the securitized assets and transaction’s cash collateral accounts Aside from the coupon rate paid to investors, the provide most of the credit support. These cash col- largest expense in structuring an asset-backed secu- lateral accounts and separate junior classes of rity is the cost of credit enhancements. Issuers securities protect the senior class by absorbing constantly attempt to minimize the costs associated losses before the cash flows from the senior certifi- with providing credit protection to investors. cate are interrupted.

Credit enhancements come in several different Senior/subordinate structures can be layered so that forms, although they can generally be divided into each position benefits from all the credit protection two main types: external (third party or seller’s of the positions subordinate to it. The junior posi- guarantees) or internal (structural or cash flow tions are subordinate in the payment of both driven). principal and interest to the senior positions in the securities. External/Third Party Credit Enhancements A typical security structure may contain any of the As a general rule, third party credit enhancers must following internal enhancements, which are pre- have a credit rating at least as high as the rating sented in order from junior to senior, that is, from sought for the security. Third party credit support is first to absorb losses to the last: often provided through a letter of credit or surety bond from a highly rated bank or insurance com- Excess spread. The excess spread is created from pany. Currently, there are only a few highly rated the monthly portfolio yield on the receivables sup- third party credit enhancers. Further, there is the porting an asset-backed security. The excess spread possibility that the ratings assigned to a third party is generally greater than the coupon’s servicing credit enhancer could be lowered. Although it rarely costs and expected losses for the issued securities. happens, such an event could cause the security Any remaining finance charges after funding, ser- itself to be downgraded. As a result, issuers are re- vicing costs, and losses, is called excess spread. lying less and less on third party credit This residual amount may eventually revert to the enhancements. institution/seller as additional profit. However, it is available for the trust to cover any losses that are Third party letter of credit. For issuers with credit greater than what is normally expected for the port- ratings below the level sought for the security is- folio. Such losses may arrive from higher than sued, a third party may provide a letter of credit to projected charge-offs or servicing costs, or lower cover a certain amount of loss or percentage of than projected revenues. losses. Any draws on the letter of credit protection are often repaid (if possible) from subsequent ex- Cash collateral accounts. These are segregated cess cash flows from the securitized portfolio. trust accounts, fully or partially funded at the outset of the deal. They can be drawn on to cover short- Recourse to seller. Primarily used by nonbank or falls in interest, principal, or servicing expenses if thrift issuers, the originator/transferor provides a excess spread is reduced to zero. The account can limited guarantee covering a specified maximum be funded by the issuer, but may be funded by a amount of loss on the pool. loan from a third party financial institution. This loan will be repaid from the proceeds of the trust assets, but only after all secured certificate holders have been paid in full.

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Collateral invested amount (CIA). The CIA is a transfer of servicing as unsafe and unsound banking privately placed ownership interest in the trust as- practices.1 sets, subordinate in payment rights to all investor certificates. It may be referred to as a residual in- Illustration of Credit Enhancement/Loss Positions terest in the trust or the “equity piece,” because a seller often creates and holds this interest to provide To illustrate the credit enhancement concept, losses credit support for the issue. It may, however, be in a hypothetical securitization would be absorbed sold to an outsider. as follows.

Like a layer of subordination, the CIA serves the First loss tranche. Usually the residual interest, is same purpose as the cash collateral account. It typically retained by the originator and is estab- makes up for shortfalls if excess spread is insuffi- lished at the normal expected rate of portfolio credit cient. If the CIA absorbs losses, it can be losses. The excess spread, which funds the residual reimbursed from any available excess spread. The interest, normally should absorb expected portfolio CIA is usually an uncertificated ownership interest. losses, so that the credit support provided by the originator’s investment provides an additional cush- Subordinate security classes. Subordinate security ion against unexpected losses. classes are junior in claim to other debt. They are repayable only after other classes of the security Second loss tranch. Referred to as the cash collat- with higher claims have been satisfied. Some secu- eral account, typically covers losses that exceed the rities may contain more than one class of originator’s retained interest. This second level of subordinated debt, and one subordinated class may exposure is usually capped at some multiple of the have a higher claim than other such positions. pool’s expected losses (customarily between three and five times these losses), depending on the de- Performance-based enhancements. Most securities sired credit ratings for the senior positions. A high contain performance related features designed to grade, well capitalized credit enhancer that is able protect investors (and credit enhancers) against to diversify the risk often absorbs this risk. portfolio deterioration. Poor portfolio credit performance can trigger additional safeguards, such as Senior tranches. Investors that buy the asset- an increase in the spread account available to ab- backed securities themselves bear the lesser credit sorb losses or the accelerated repayment of risk of the senior tranches. These are often divided principal (early amortization). into a senior tranch and a mezzanine tranch. Al- though these investors are exposed to other types of The earliest performance-based enhancement typi- risk, such as prepayment or interest rate risk, senior cally requires the capture of excess spread within level classes of asset-backed securities typically the trust to provide additional credit protection have less exposure to credit loss because of the when the portfolio begins to show signs of deterio- credit support offered by the junior tranches as well ration. If delinquencies and loss levels continue to as other credit enhancements. deteriorate, early amortization may occur in revolving securitizations. Early amortization triggers are Obtaining Ratings for the Securities usually based on a three-month rolling average to ensure that amortization is accelerated only if the The originator or pool sponsor will often negotiate pool’s performance is consistently weak. with the rating agencies about the type and size of the internal and external credit enhancements. The However, you should criticize covenants that cite size of the enhancement is dictated by the credit supervisory thresholds or adverse supervisory ac- quality of the asset pool and the rating desired for tions as triggers for early amortization events or the the senior security. For example, to achieve the same rating, a security based on a poorer quality

1 See “Interagency Advisory on the Unsafe and Unsound Use of Covenants Tied to Supervisory Actions in Securitization Documents,” May 23, 2002.

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asset pool will require a greater level of credit en- Phase 4: Issuing Interests in the Trust hancement. For the highest rating, the rating agencies require that the level of protection be suf- Depository institution issuers have two primary ficient to shield the senior security against a concerns regarding the securitizations. They seek to depression scenario set of events. ensure the following:

Rating agencies perform a critical role in structured · A security interest in the assets securitized is finance – evaluating the credit quality of the trans- perfected. actions. Such agencies are credible because they possess the expertise to evaluate various underlying · The security is structured to preclude the asset types, and because they do not have a finan- FDIC’s voiding the perfected security interest. cial interest in the securities. Ratings are important because investors generally accept ratings by the By perfecting security interest, a lender protects the major public rating agencies in lieu of performing trustee’s property rights from third parties who may their own in-depth due diligence investigation of the have retained rights that impair the timely payment underlying assets or servicer. of the debt service on the securities. Typically, a trustee requires a legal opinion stating that the trust The issuer determines whether it will seek a rating has a first priority perfected security interest in the for its securities based on recommendations from pledged receivables. In general, filing Uniform the underwriter. Most nonmortgage asset-backed Commercial Code documents is sufficient for unse- securities are rated. The large public issues are cured consumer loan receivables such as credit rated because the investment policies of many cor- cards. For other types of receivables, additional porate investors require ratings. Private placements steps (title or mortgage assignments and recordings, are often rated because qualifying buyers such as etc.) may be required to perfect the trust’s security financial institutions and insurance companies are interest in the receivables and the underlying collat- significant investor groups. Financial institutions eral. use ratings to satisfy regulatory and board of director requirements, and insurance companies use The underwriter is responsible for advising the ratings to assess capital reserves against their in- seller on how to structure the security, and for pric- vestments. Many regulated investors, such as life ing and marketing it to investors. Underwriters are insurance companies, pension funds, and, to some often selected based on their relationships with in- extent, commercial banks can purchase only limited stitutional investors and for their advice on the amounts of securities rated below investment grade. terms and pricing requirements of the securities market. They are also generally familiar with the The rating agencies review four major areas: legal and structural requirements of regulated insti- tutional investors. · Quality of assets being sold. The largest purchasers of securitized assets are · Abilities and strength of the originator/servicer. pension funds, insurance companies, fund manag- · Soundness of the transaction’s overall struc- ers, and to a lesser degree, thrift institutions and ture. commercial banks. The most compelling reason for investing in an asset-backed security has been their · Quality of the credit support. return relative to other assets of comparable quality and risk. From this review, the agencies assess the likelihood that the security will pay interest and principal ac- On the closing date of the transaction, the receiv- cording to the terms of the trust agreement. The ables are transferred, directly or indirectly, from the rating agencies focus on the credit risk of the asset- institution to the qualifying special purpose vehicle backed security. They do not express an opinion on (trust). The trust issues certificates representing market value risks arising from interest rate fluctua- beneficial interest in the trust, investor certificates, tions, prepayments, or on the suitability of an and, in the cases of revolving asset structures, a investment for a particular investor. transferor or seller certificate.

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Investor’s Certificate Pass-through Securities

Investor certificates are sold in either public offer- Under a pass-through structure, the cash flows from ings or private placements, and the proceeds, net of the underlying pool of assets are passed through to issue expenses, are remitted to the seller. There are investors on a pro rata basis. two main types of investor interest in securitized assets, a discrete interest in specific assets, and un- The payment distribution for securities backed by in- divided interest in a pool of assets. The first type of stallment loans is tied to loan performance. Interest is ownership interest is issued for asset pools that customarily paid monthly, and the principal included in match the maturity in cash flow characteristics of each payment will depend on the amortization schedule the security. The second type of ownership interest and prepayment rate of the underlying collateral. is used for short-term assets such as credit card receivables or advances against home equity lines of Pay-through Securities credit. For the short-term assets, new receivables are generated and added to the pool as existing re- For revolving asset types such as credit cards, trade ceivables liquidate. The investors’ interest in the receivables, home equity lines, the cash flow has two pool automatically applies to the new receivables. phases:

Seller’s Interest · The revolving period. · The principal pay down period, or amortization When receivables backing securities are short term phase. or turn over rapidly, as do trade receivables or credit cards, the issuer must actively manage the During the revolving period, investors receive their pro cash flows associated with receivables. One objec- rata share of the gross portfolio yield based on the tive is to keep the outstanding principal balance of principal amount of their certificates and coupon rate. the investor’s interests equal to the certificate The remaining portion of their share of the finance amounts. To facilitate this equalization, an interest, charges above the coupon rate is available to pay the known as the seller’s or transferor’s interest, is not servicing fees and to cover any charge-offs, with re- allocated to investors, but retained by the seller. sidual amounts generally retained by the seller or The seller’s interest serves two primary purposes: credit enhancement provider as excess spread. to provide the cash flow buffer when account payments exceed account purchases and to shore up The cash flow waterfall for credit card securities may reductions in the receivable balance attributable to look like this (percentages are based on investors’ pro dilution and noncomplying receivables. rata share of the outstanding receivables): To calculate the size of the seller’s interest, subtract the amount of securities issued by the trust from the Revenue balance of the principal receivables in the trust. The · Finance charges 14.0% seller’s interest is generally not a form of credit en- · Annual fees 0.5% hancement for the investor interest; however, it may be, and if so, evaluate it as such. · Late fees and other fees 1.2% · Bank interchange 1.8% Types of Asset-Backed Securities Gross portfolio yield 17.5%

Asset-backed securities may be structured as “pass- Expenses throughs” or “pay-throughs.” · Investor coupon 6.0% · Servicing expense 2.5% · Charge-offs 5.5% Total expenses 14.0% Excess spread 3.5%

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A decline in the actual performance of the loan pool Institutions should develop a business plan to estab- from the original assumptions can quickly erode the lish parameters for its securitization activities. The expected spread. business plan should establish policies for the securitization activity, including: During a revolving period, the issuer uses monthly principal collections to purchase new receivables · How the activity fits within the institution’s generated in the designated accounts or to purchase overall strategic plan. a portion of the seller’s participation if there are no · A performance measurement process. new receivables. If a percentage of the seller’s interest falls below the prescribed level of principal · A list of potential counterparties (credit enhan- outstanding because of a lack of new borrowings cers, underwriters, trustees, etc.). from the designated accounts, new accounts may be · A process by which management and the board added. of directors can be assured that adequate controls, procedures, systems, and risk analysis The amortization period occurs next. During the techniques will be maintained throughout all amortization period, the trust no longer uses the phases of the securitization process. investor’s share of principal collections to purchase replacement receivables. It returns these proceeds to The business proposal should at least provide a de- investors as received. scription of the following: This is the simplest form of principal repayment. · Proposed products, markets, and business strat- However, because some investors prefer more sta- egy. ble returns of principal, some issuers have created structures to accumulate principal payments in a · Risk management considerations. trust account rather than simply passing principal · Methods to measure, monitor, and control risk. payments through to the investors as received. · Accounting, tax, and regulatory implications. For example, the trust may pay principal on a spe- · Legal implications. cific, or “bullet” maturity date. Bullet maturities are typically either hard or soft, depending on how the · Necessary information system enhancements or structure pays when funds in the accumulation ac- modifications. count are not sufficient to pay the investors in full on the scheduled maturity date. Under a hard bullet Many key parties will be involved, including ac- structure, a third party guarantee covers any short- counting, information technology, finance, legal, fall. Under a soft bullet structure, the trust audit, credit risk, and senior line management. All distributes the entire accumulation account to the affected departments should review and comment investors and pays additional funds as received. on the proposal. A rigorous approval process for Soft bullet structures usually include an expected new products and activities lessens the possibility maturity date and a final maturity date. that management might underestimate the level of due diligence needed for proper risk management MANAGING SECURITIZATION ACTIVITIES and the ongoing resources required for effective process management. Institutions that have enjoyed the full range of benefits offered by securitization have established Independent Risk Management Function proper management systems and controls to oversee and monitor all aspects of the securitization proc- Institutions engaged in securitizations should have ess. Because of the risks involved in securitization, an independent risk management function commen- first time securitizers should thoroughly review surate with the complexity and volume of each step of the proposed transaction before com- securitization activity and overall risk exposure. mitting to it. The risk management function should ensure that securitization policies and operating procedures, including clearly articulated risk limits, are in place

Office of Thrift Supervision September 2003 Regulatory Handbook 221.11 SECTION: Asset-Backed Securitization Section 221

and appropriate for the institution’s circumstances. The absence of quality MIS will hinder manage- A sound asset securitization policy should include ment’s ability to monitor specific pool performance or address, at a minimum: and securitization activities more broadly. At a minimum, MIS reports should address the follow- · A written and consistently applied accounting ing: methodology. · Securitization summaries for each transac- · Regulatory reporting requirements. tion. The summary should include relevant · Valuation methods, including FAS 140 residual transaction terms such as collateral type, facil- value assumptions, and procedures to formally ity amount, maturity, credit enhancement and approve changes to those assumptions. subordination features, financial covenants (termination events and spread account capture · Management reporting. “triggers”), right of repurchase, and counter- · Exposure limits and requirements for both ag- party exposures. Management should ensure gregate and individual transaction monitoring. the summaries are distributed to all personnel associated with securitization activities. It is essential that the risk management function · Performance reports by portfolio and specific monitor origination, collection, and default man- product type. Performance factors include agement practices. This includes regular gross portfolio yield, default rates and loss se- evaluations of the quality of underwriting, sound- verity, delinquencies, prepayments and ness of the appraisal process, effectiveness of payments, and excess spread amounts. The re- collections activities, ability of the default manage- ports should reflect performance of assets, both ment staff to resolve severely delinquent loans in a on an individual pool basis and on total man- timely and efficient manner, and the appropriate- aged assets. These reports should segregate ness of loss recognition practices. specific products and different marketing cam- paigns. Because the securitization of assets can result in current recognition of anticipated income, the risk · Vintage analysis for each pool using monthly management function should pay particular atten- data. Vintage analysis helps management un- tion to the types, volumes, and risks of assets being derstand historical performance trends and their originated, transferred, and serviced. Both senior implications for future default rates, prepay- management and the risk management staff must be ments, and delinquencies, and, therefore, alert to any pressures on line managers to originate retained interest values. Management can use abnormally large volumes or higher risk assets in these reports to compare historical performance order to sustain ongoing income needs. Such pres- trends to underwriting standards, including the sures can lead to a compromise of credit use of a validated credit-scoring model, to en- underwriting standards. This may accelerate credit sure loan pricing is consistent with risk levels. losses in future periods, impair the value of retained Vintage analysis also helps in the comparison interests, and potentially lead to funding problems. of deal performance at periodic intervals and validates retained interest valuation assump- The risk management function should also ensure tions. that appropriate management information systems · Static pool cash collection analysis. This (MIS) exist to monitor securitization activities. Re- analysis entails reviewing monthly cash receipts porting and documentation methods must support relative to the principal balance of the pool to the initial valuation of retained interests and ongo- determine the cash yield on the portfolio, com- ing impairment analyses of these assets. Pool paring the cash yield to the accrual yield, and performance information has helped well-managed tracking monthly changes. Management should institutions to ensure, on a qualitative basis, that a compare the timing and amount of cash flows sufficient amount of economic capital is being held received from the trust with those projected as to cover the various risks inherent in securitization part of the FAS 140 retained interest valuation transactions. analysis on a monthly basis. Some master trust

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structures allow excess cash flow to be shared the pooling and servicing agreements. Perform- between series or pools. For revolving asset ance triggers include early amortization, spread trusts with this master trust structure, manage- capture, changes to overcollateralization re- ment should perform a cash collection analysis quirements, and events that would result in for each master trust structure. These analyses servicer removal. are essential in assessing the actual performance of the portfolio in terms of default and During initial due diligence for securitization trans- prepayment rates. If cash receipts are less than actions, the underwriter (often an investment those assumed in the original valuation of the banker), the rating agencies, and the independent retained interest, this analysis will provide outside accountants thoroughly review the institu- management and the board with an early warn- tion’s securitization process. The institution’s ing of possible problems with collections or internal oversight is also critically important extension practices, and impairment of the re- throughout the process and while any securities are tained interest. still outstanding. · Sensitivity analysis. Measuring the effect of The institution’s risk control unit should report di- changes in default rates, prepayment or pay- rectly to a senior executive to ensure the integrity of ment rates, and discount rates will assist the process. The unit, which should evaluate every management in establishing and validating the role the institution has in securitization, should pay carrying value of the retained interest. Man- special attention to the origination and servicing agement should perform stress tests at least operations. In the origination area, the unit should quarterly. Analyses should consider potential take significant samples of credit actions, verify adverse trends and determine “best,” “prob- information sources, and track the approval proc- able,” and “worst case” scenarios for each ess. event. Other factors to consider are the impact of increased defaults on collections staffing, the In the servicing area, the unit should track payment timing of cash flows, “spread account” capture processing, collections, and reporting from the triggers, overcollateralization triggers, and credit approval decision through the management early amortization triggers. An increase in de- and third party reporting process. The purpose of faults can result in higher than expected costs these reviews is to ensure that activities are consis- and a delay in cash flows, decreasing the value tent with policy and trust agreements and to detect of the retained interests. Management should operational weaknesses that might leave the institu- periodically quantify and document the poten- tion open to fraud or other problems. Risk tial impact to both earnings and capital, and managers often suggest policies or procedures to report the results to the board of directors. prevent problems, such as documenting exceptions Management should incorporate this analysis to the institution’s policies. You should follow up into their overall interest rate risk measurement on any irregularities discovered in the audits and system.2 Examiners will review the analysis discuss them with senior management. conducted by the institution and the volatility associated with retained interests when assessing the Sensitivity to Market Risk component Monitoring Securitization Transactions rating. Management should use the MIS reports to monitor · Statement of covenant compliance. Manage- the performance of the underlying asset pools for all ment should affirm at least monthly compliance outstanding deals. Although the institution may with deal performance triggers as defined by have sold the ownership rights in controlling the assets, the institution’s reputation as an underwriter

2 or servicer remains exposed. To control the effect Under the Joint Agency Policy Statement on Interest Rate of deterioration in pools originated or serviced by Risk, institutions with a high level of exposure to interest rate risk relative to capital will be directed to take corrective ac- the institution, management should have a system- tion. Thrift institutions can find OTS guidance on interest atic monitoring process to track pool quality and rate risk in Thrift Bulletin 13a - Management of Interest Rate performance throughout the life of the transactions. Risk, Investment Securities, and Derivative Activities.

Office of Thrift Supervision September 2003 Regulatory Handbook 221.13 SECTION: Asset-Backed Securitization Section 221

Management reports on revolving transactions The purpose of your review is to assess the effect of (credit cards, home equity lines, etc.) should cover, the various securitization risks on the institution’s at a minimum: overall financial condition and performance. The risks are often difficult to identify completely, as · The portfolio’s gross yield. their form may be masked by holding company, affiliate, and servicing relationships within the cor- · Delinquencies. porate structure. · Number and status of re-aged accounts. You should determine whether management · Charge-off rates. promptly and properly identifies and controls the · The base rate (investor coupon plus servicing risks from the institution’s securitization activities, fees). and that capital levels reflect these risks. Your con- clusions from this evaluation will determine an · Monthly excess spread. institution’s CAMELS composite and component · The rolling three month average excess spread. ratings, other risk assessments, and the adequacy of its capital. · The monthly payment rate. · Servicing advances. Effective securitization risk management requires the institution to do the following: Management reports of securities backed by installment loans (automobiles, equipment leases, · Understand and control the amount of risks in- etc.) should cover, at a minimum: volved in the entire transaction. · Identify the risks transferred from one party to · The charge-off rate. another, and the risks it retains. · The net portfolio yield. Invariably, the selling institution will retain some · Number and status of extended, deferred or re- risks of the securitization. Securitization transac- written accounts. tions often receive substantial attention early in · Delinquencies (by age and severity). their lives, but the level of scrutiny often declines over time. Many of the problems that institutions · Principal prepayment speeds. have experienced, such as rising delinquencies and · Outstanding principal compared to original se- charge-offs, inaccurate investor reporting, and bad curity size. publicity, occurred in the later stages of the transaction. The institution should carefully supervise and · Servicing advances. monitor a transaction for the entire duration of its involvement. SECURITIZATION RISKS The following subsections highlight the primary The primary risks associated with securitization risks and management practices that should be in activities are related to strategic planning, credit, place at financial institutions involved in asset- earnings and capital management, liquidity, credit backed securitization. quality of the remaining on-book portfolio after securitization, servicing, compliance, market, Strategic Risk reputation, and fiduciary/trustee exposures. Strategic risk is the risk to earnings and capital The types and amounts of risk will vary with the arising from adverse business decisions or their im- roles played by financial institutions in the securiti- proper implementation. This risk involves the zation process, transaction structures, activity compatibility of an organization’s strategic goals, volumes, the risk and duration of underlying assets, the business strategies developed to achieve those and the amount of credit risk of any retained inter- goals, the resources deployed against those goals, ests. and the quality of implementation.

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Securitization is an activity that can involve almost program. A rigorous approval process for new every major role played by a financial institution, products or activities lessens the risk that manage- including lending, servicing, credit enhancing, fi- ment may underestimate the level of due diligence nancial engineering, fiduciary, and distributing. The required for risk management or the ongoing re- strategic decision to participate in securitization sources required for process management. should be made in the context of an institution’s overall growth, profitability objectives, funding al- Credit Risk ternatives, operational capacities, and capital strength. A post-mortem analysis of failed securitizers usually points to poor underwriting, poor credit The assessment of an institution’s strategic risk management, and/or the originator’s penchant for exposure includes the long term effects of securiti- investing in extremely high risk assets. During the zation operations, profitability, and asset/liability early stages of the securitization, originators be- management. Exposure increases when transactions lieved that when their loans were securitized and are undertaken without due consideration of their sold, most credit risk was transferred to the inves- long term internal resource requirements. For ex- tors. This assumption has been proven repeatedly to ample, while the existing systems and collection be inaccurate, as credit losses on the asset pools department resources may be adequate for current have often been the root cause of the failures of operations, securitization transactions are often ac- such securitizers. companied by rapid growth in the volume of lending and the need for more timely and precise reporting Securitizers often underestimate the credit risks re- requirements. At a minimum, this may require im- tained in portfolios they have securitized. While the proved computer systems and software and originating/selling institution may transfer some of dedicated collections, operational, and reporting its credit risk to investors in a securitization, it will personnel. often retain substantial interests (of various forms) in the asset pool. The interests retained by the insti- Prudent Risk Management Practices tution often provide credit support for the rest of the pool, and thus embody a concentrated form of Institutions should integrate securitization activities credit risk. into critical planning processes, such as the firm- wide strategic plan, asset/liability management The retained credit risk of the underlying assets is plan, contingency funding plans, and the capital the greatest risk of securitization. Any shortfall in plan. Management should consider measures of the cash flows due to losses in the loan pool affects retained risk and/or the potential exposure of earn- the value of the interests providing credit support ings and capital in each of these areas under first, as those interests are the last to be paid. As a expected and stressed market conditions. result, the residual interest holder is in a “first dollar loss” position and is exposed to the credit and Management and the board of directors of first time other risks from the entire loan pool. securitizers should ensure that the proposed process has been thoroughly reviewed by all affected de- Because originating institutions will absorb virtu- partments before the first transaction. Securitizers ally all of the expected losses and most of the should assign responsibility for managing securiti- unexpected losses from both on-balance-sheet and zation to a dedicated individual or department. The securitized loan pools, the best overall protection manager or group should have the experience and against credit risk is to generate high quality loans. skills to understand the various components of se- Institutions can only accomplish this through the curitization and the authority to communicate and establishment and maintenance of sound credit act across product and department lines. The man- standards, a strong, independent internal loan re- ager should consider the effects that proposed view function, and effective internal controls over changes in policies or procedures on origination or all its lending and servicing activities. servicing may have on outstanding or future securitization issues. Management should understand and It is also critical that experienced lending managers, approve any material changes to a securitization not investment bankers, marketing, or other vol-

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ume-oriented parties, set and maintain the institu- Some red flags to consider when evaluating the tion’s lending standards. Sustained periods of origination and account management activities of dramatic growth and aggressive “teaser-rate” and institutions with securitization programs include: other “special offers” are often early indicators of market-driven lending programs that may indicate · Poor underwriting. compromised lending standards. · Poor credit risk management. If an institution engages in high volumes of poor · The originator’s penchant for investing in ex- quality lending, it will be exposed to a substantial tremely high risk assets and then retaining level of credit risk. Institutions should not assume residual interests in the securitization. that they can “manage” the additional levels of risk · Disproportionate production pay incentives. by transferring much of the credit risk through securitizations, higher pricing, and high loan volumes. Loan volume often creates more problems than it Prudent Risk Management Practices solves. Large spreads created by high loan pricing often prove inadequate, as losses and prepayments Management should be diligent in its ongoing man- can easily exceed projections. aging and monitoring of credit risk in securitization activities. A key component of managing credit risk Charging higher interest rates for high risk borrow- is proper product offering, underwriting, and ac- ers may seem like an attractive strategy. However, count management activities. Consequently, an borrowers will avoid those high rates if they can. institution should select a sound loan program, then For example, if subprime borrowers’ credit condi- properly underwrite, and manage the underlying tion improves, they are likely to refinance their assets. Management should identify, measure, existing loans into ones with lower rates. As a re- monitor, and control the credit risk retained by the sult, excess servicing spreads disappear, making institution. residual interest-only (IO) strips based upon them worthless. If, on the other hand, their financial con- Loss Exposure dition worsens, they default and again the express spread disappears. Management must evaluate how much risk the institution retains after the securitization. In most Overly optimistic projections of loan performance securitization structures, credit risks are allocated have led securitizers to undertake larger and larger so that the transferor, with its retained interests, volumes of high risk loans. The sheer volumes of bears default losses up to a predefined point, typi- these loans create servicing, collections, operating cally at a level based on historical losses and expense, information systems, and liquidity chal- projected performance. The transferor’s exposure is lenges. When such problems are combined with a function of its retained interests, including the higher than projected losses, the institution may fail. excess portfolio yield. As pool performance deterio- Consequently, institutions should be conservative in rates and charge-offs increase, excess spread, which estimating pool performance projections. would normally be returned to the institution, declines. Once the excess spread is exhausted, the risk Poorly designed employee compensation plans have of credit default customarily shifts to the credit en- resulted in poorly performing asset pools. Compen- hancers, typically up to some additional multiple of sation plans for the lending, underwriting, and projected losses. Only losses above these multiples servicing staff should balance short term and long- are borne by investors. term interests. You should consider criticizing plans that disproportionately reward production staff Remaining On-Balance-Sheet Exposure based on the volume of originations without regard to underwriting standards. Servicing compensation Securitization prices and marketability increase should not be tied to incentives that encourage col- with the quality of the underlying assets and the lection staff to re-age or renew loans in an effort to predictability of their cash flows. Higher quality mask true delinquency levels. assets also require less credit support in the form of excess collateral or seller-retained interests. This

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may tempt institutions to “cherry pick” loans that acceleration of earnings that flow through to the go into the securitized portfolios, leaving lower equity account on an after-tax basis. The capital- quality loans on their balance sheets. If this signifi- ized asset, commonly a residual asset or IO strip, cantly increases the risk profile of the institution, represents the present value of the anticipated fu- you should consider requiring additional capital and ture excess spread cash flow. The recorded allowance for loan losses for its remaining on- investment in these assets and the resulting contri- balance-sheet assets. This risk is addressed more butions to earnings and equity are dependent on fully below in the section on adverse selection. assumptions related to the life of the asset and the future timing and amount of cash flows, including Moral Recourse charge-offs, loss severity, prepayment rates, and discount rates. Most prospectuses of asset-backed securities clearly state, “The offering is not an obligation of The process of accelerating earnings based on fu- the issuing institution.” Despite this absence of a ture expectations increases the potential for legal obligation, an issuer may feel compelled to earnings and capital volatility. While federally in- protect its name and reputation in the securitization sured depository institution regulatory capital marketplace by providing support for poorly per- requirements require dollar-for-dollar risk-based forming asset pools. Because issuers in the past capital coverage of IO strips, any material impair- have taken steps to prevent ratings downgrades or ment of these assets will result in declines to GAAP early amortizations, investors may have come to earnings and capital levels. Notwithstanding the expect sponsors to support distressed issues. coverage required under regulatory capital rules, sudden and sizeable write-downs or restatements of The decision to provide support for poorly perform- earnings and capital may trigger concerns among ing asset pools is difficult. It entails the immediate funds providers, shareholders, customers, and em- cost of the noncontractual support given, and it may ployees. entail other accounting, legal, and regulatory issues. If an institution provides support for one securitiza- Residual interests in securitized loans can be among tion, OTS may disallow the sale treatment on some the most volatile assets on the balance sheet. or all of the issuer’s other securitized transactions. Institutions may have to take large write-downs of This can have a critical impact on earnings and residual interests if actual conditions vary from the capital. assumptions management uses in its valuation model or if the model itself is flawed. For example, You should realize, however, that rescuing an issue institutions may have to write-down IO strips if from early amortization and losing the sale treat- prepayment speeds are faster than assumed, portfo- ment may be the better of two unfavorable lio yields are lower than expected, asset quality outcomes, since early amortization could affect fu- performance is less than anticipated, or appropriate ture securitization activities, as well as the ratings discount rates are higher than assumed. of the institution’s other transactions. Nevertheless, you should review such actions and consider the During an examination, you should review all as- likelihood that the institution will find itself com- pects of the valuation process. Several red flags pelled to provide such support for its other issues. may exist that warrant a detailed review of an institution’s modeling and valuation process, including: Other Securitization Risks · Inconsistency and over optimism in the initial Modeling and Valuation Risk and ongoing valuation of residual interests. · Questionable valuation methods have included Institutions that securitize assets should follow FAS incorrect cash flow modeling, unsupported loss 140 in accounting for their securitized transactions. assumptions, inaccurate prepayment estimates, Under this accounting rule, transactions that qualify and inappropriate discount rates. Note: As re- as a sale must recognize any “gain-on-sale” at the siduals typically have no liquid secondary time of the securitization. This gain is effectively an market, their estimated market values are diffi-

Office of Thrift Supervision September 2003 Regulatory Handbook 221.17 SECTION: Asset-Backed Securitization Section 221

cult to verify. This lack of verifiability has market has also not been tested during a period of sometimes led to disagreements with institu- prolonged economic downturn. Higher than ex- tions and their accounting firms about proper pected default rates reduce the value of residual valuation. assets, as these are in the most junior position, and of the servicing rights, as future payments cease · Poor documentation with which to confirm that and collection costs increase when loans default. underlying assumptions are well supported, reasonable, and consistent. Third, subprime borrowers will refinance their · Significant differences between assumptions loans to reduce the interest they pay both if overall and actual performance. interest rates drop, and if their credit ratings improve. This second aspect (credit-induced Residual interests are exposed to a significant level prepayment) is a phenomenon not experienced with of credit and interest rate risk that make their values prime mortgages, and further complicates the extremely sensitive to changes in the underlying valuation of subprime servicing rights. conditions. As a result, their value may provide little real capital support, particularly in times of Other Credit Issues stress. Stress testing. Institutions should use cash flow You should review the original assumptions used in projection models to estimate the performance and the valuations, compare them with actual perform- value of their securitized asset pools. These models ance, and require valuation adjustments if the trace projected funds through the proposed transac- underlying assumptions are not reasonable or prop- tion structure, and account for distribution of cash erly supported. flows through a variety of performance scenarios. Typically, loan performance and the resulting cash The method and key assumptions used to value the flows will vary significantly, depending on differing retained interests and servicing assets or liabilities market and economic conditions. Institutions should must be reasonable and fully documented. The key subject their proposed structures to several itera- assumptions in all valuation analyses should be tions of stress testing to provide better insight into conservative, logical, and consistent. It is important the potential loss exposures of the institution, of that management quantifies the assumptions at least other credit enhancers, and of investors under most quarterly and maintains supporting documentation likely and worst case scenarios. for all changes made. Institution policies should define the acceptable reason for changing assump- The effectiveness of modeling in providing useful tions and require appropriate management performance projections depends on the originator’s approval. adherence to prudent underwriting standards. Mod- els can become outdated or results skewed because Subprime Residual Valuation Issues of incomplete or inaccurate information. To control potential weaknesses in the models, management Securitized subprime loan pools present an even should back-test their model results regularly, re- greater challenge for the proper valuation of residu- validating the logic and algorithms used and ensure als and servicing rights for several reasons. First, the integrity of the data entry and assumptions. by definition, subprime loans are extensions of credit to borrowers with weak credit histories. The Vintage analysis. Thrift management should per- ability of these borrowers to make loan payments is form vintage analysis to track delinquency, very sensitive to changes in economic conditions. A foreclosure, and loss ratios for similar products slowdown in the economy can lead to a substantial over comparable time periods. The objective is to increase in subprime mortgage delinquencies, while identify sources of credit quality problems early so having little impact on the performance of prime that management can take corrective action. mortgages. Because loans do not reach peak delinquency levels Second, given the relative newness of subprime until they have seasoned for several months or even lending, institutions’ involvement in the subprime years, tracking the payment performance of loans

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over time allows the institution to evaluate the qual- vances on these accounts. This risk threatens firms ity of newer loans over comparable timeframes. It that do not control maturities of individual securi- then can benchmark a new loan cohort against pre- tized transactions with overall planned balance vious groups to predict the effect that aging will sheet growth. In certain situations, servicing obliga- have on its future performance. tions may also require the institution to advance funds to investors and other parties prior to receiv- Prudent Risk Management Practices ing payments from underlying borrowers.

Management should use conservative and well- A concentration or over reliance on any funding supported assumptions when determining the value source or market, including the asset-backed mar- of residual assets. Even well supported assumptions kets, can increase liquidity risk. Over reliance exists can change due to changes in the marketplace. if an institution is not able to meet its strategic ob- Management should perform periodic stress testing jectives without that specific funding source. Due to of assumptions to identify and quantify the potential the credit sensitive nature of the capital markets, impact to earnings and capital levels of deviations securitization may be subject to market disruptions, from the assumptions being used. An independent either temporary or long term in nature. third party, who may include independent auditors or others, should validate the assumptions and mod- Liquidity risk is directly related to the degree of eling process to ensure accuracy. dependence on securitization as a funding source. Disruptions in the asset-backed securities market or Management information systems should track his- deterioration in an institution’s financial condition, torical performance as well as actual cash particularly its asset quality or servicing capabili- collections. Management should compare the timing ties, may limit the asset-backed securities market as and amount of cash flows received from the trust a reasonably priced source of liquidity. with those projected as part of the residual valuation analysis. Vintage analyses and monitoring of Extensive reliance on securitization as a funding current positions and trends against early warning source creates incentives for institutions to engage triggers are also standard tools that institutions use in questionable market practices to ensure the con- to oversee securitization activities. tinued availability of funding. Most, if not all, of the pressures associated with institutions retaining As part of the ongoing residual valuation process, risk and implicitly supporting past issue securitiza- the unit responsible for valuing the residual asset tions are based on the desire to maintain ongoing should discuss the forecasts used to develop as- access to securitization markets. sumptions with the business unit responsible for underwriting. The units should discuss any changes This pressure grows exponentially when securitiza- in underwriting and their potential impact to valuation becomes the only viable method of funding tion assumptions including default rates, ongoing operations and meeting business objectives. prepayment speeds, and loss severity. The under- The substantial fixed costs associated with estab- writing group should also work with the servicing lishing and maintaining origination and servicing area to ensure technology and staffing resources are facilities and staff require a continual high volume sufficient to manage potential increases in delin- of originations and securitizations. Competitive quencies and default levels. pressures from firms entering this business have also exacerbated these problems by narrowing mar- Liquidity Risk gins and increasing prepayments as borrowers refinance, leaving one lender for another that offers Liquidity risk arising from securitization activities a better deal. can be heightened by over dependence on a single segment of the capital markets. Securitization Both the scheduled and early amortization of out- transactions involving unfunded or revolving credit standing asset-backed securities containing lines may be a drain on an institution’s liquidity revolving or unfunded credit lines may result in the position if the institution has to make future ad- institution having to fund any new advances itself, with its own on-balance-sheet cash resources. In

Office of Thrift Supervision September 2003 Regulatory Handbook 221.19 SECTION: Asset-Backed Securitization Section 221

each case, the originating institution must make a ther scheduled or early amortization. The liquidity decision to grant future advances to customers or to implications of financing new advances under terminate the credit relationship. If the accounts are scheduled amortization can be managed by stagger- of reasonable credit quality, the institution’s trade- ing the maturity periods of transactions and through off is one of maintaining desired customer relation- the maintenance of sound underwriting and servic- ships at the cost of on-balance-sheet funding. ing processes.

Other liquidity issues related to securitization that Although the probability of an early amortization can affect the institution’s cash position include event may be extremely low, the impact of such an servicer obligations and/or liquidity agreements. As occurrence will likely be quite severe. Management a servicer for certain asset types, a financial institu- should continually monitor the performance of the tion may be responsible for managing the timing underlying asset pool and other factors that might differences between payments on the underlying trigger an early amortization. Effective monitoring collateral and the scheduled note payments by mak- will allow the institution to better manage the situa- ing advances. In addition, the institution may act as tion. Beyond enhanced monitoring systems and a liquidity agent for its own securitization transac- treasury preparations, institutions that securitize tion or may provide a liquidity facility for third these types of assets should also maintain an ade- parties. quate level of capital to facilitate access to alternative funding sources. Prudent Risk Management Practices Management should understand the obligations un- Current and planned securitization activities should der the various types of servicing agreements and be a critical factor in both day-to-day liquidity liquidity facilities and incorporate into ongoing li- management and the contingency funding planning quidity planning. Management should incorporate processes. Ideally, the institution’s investor base expected and unexpected cash requirement into li- will be deep and diverse. Concentrations among just quidity plans, and maintain adequate levels of a few sources raise the risk of losing access to the capital to cover this potential funding obligation. capital markets at a reasonable cost. Management should allocate the appropriate resources to expand All outstanding transactions should be monitored as its investor base. part of day-to-day liquidity management. The contingency planning process should contemplate both Management should actively control the scheduled short and long term interruptions in the asset- maturities for their outstanding securitization trans- backed market. At a minimum, contingency plans actions. An institution with several issues maturing should explore a series of progressively severe at the same time may experience difficulty access- funding scenarios and practical alternative sources ing the securitization market if there has been some to meet short run liquidity requirements. The need type of market disruption. In addition, problems for the plan to identify alternate sources or contin- facing other issuers of a similar product type or gency business plans will increase in direct asset class may result in a temporary increase in proportion to the prospect that the institution may funding costs, even for an institution whose portfo- lose access on economically reasonable terms. Ac- lio is performing as expected. Rating agencies will cess to several alternative sources should enable also consider the mix of funding and maturity institutions to ride out market disruptions or buy ranges for an issuer. Issuers need to maintain and enough time to restore market confidence without regularly demonstrate the flexibility to manage facing a liquidity crisis. The maintenance of a transaction maturities and fund assets in different strong capital base is a primary line of defense that markets in the event of a disruption in the asset- should provide comfort to prospective fund provid- backed securities market. ers.

Securitization of assets that contain revolving You should determine the degree of an institution’s and/or unfunded credit lines require management to reliance on securitization as a funding source. In prepare for the possible funding of future advances general, firms establish policy limits on the percent on the institution’s balance sheet as a result of ei- of an asset class that can be securitized. However,

221.20 Regulatory Handbook September 2003 Office of Thrift Supervision SECTION: Asset-Backed Securitization Section 221

these limitations would vary depending upon the Compensation plans with a short term orientation institution’s contingency funding plan, liquidity also may provide incentive for employees to gener- sources, capital position, and overall strength of ate high volumes of loans at the expense of quality risk management. controls. Adverse implications exist not only for retained loans, but also for the quality of the institu- Adverse Selection, ALLL, and Capital tion’s capitalized assets associated with a sale and the institution’s reputation in the market if one or Securitization lends itself to the use of a diverse more vintages of loans are markedly sub-par. pool of high quality assets that provide a reasonably predictable cash flow stream. This can result in in- Prudent Risk Management Practices stitutions securitizing their higher quality assets, leaving comparatively lower quality assets, and As management contemplates its initial and ongoing perhaps assets with more concentrated risk charac- use of securitization, it should perform pro forma teristics, on the balance sheet. This pattern is assessments of capital and the ALLL. Management particularly evident at institutions executing their should formally consider the implications of dispro- first few transactions as well as with asset classes portionately higher quality assets being sold and where an asset-backed market has not yet fully de- comparatively lower quality assets being retained. veloped. In either case, if not controlled, the Management should also adjust both capital and consequences can be inadequate capital and/or al- ALLL levels as needed to reflect the remaining mix lowance for loan and lease losses (ALLL) at the of assets relative to both quality and concentration institution or for a specific group of loans in the characteristics. loan portfolio. Management reports should monitor the perform- When an institution securitizes receivables, it makes ance of the underlying asset pools for all deals. To certain representations and warranties regarding control the impact of deterioration in pools origi- those receivables. If some receivables do not meet nated or serviced, a systematic reporting process the representations and warranties provided by the should be in place allowing management to track seller, the seller might have to repurchase any defi- pool quality and performance throughout the life of cient receivables or substitute them for qualifying the transaction. receivables. If the institution repurchases defective receivables or makes substitutions, its balance sheet If the credit environment deteriorates or the institu- may both increase in size and decline in quality. tion does not have the appetite or capability to This may present a supervisory concern should manage continued growth, prudence would dictate a such repurchases or substitutions be significant. reduction in originations. For institutions relying heavily on securitization gains, contingency plans At institutions where gains from the sale of securi- should exist either to absorb the less productive tized assets are a significant portion of earnings overhead into the existing earnings and capital and/or capital, the annuity-like earnings stream that structure or to employ technology and personnel in would have existed if the assets remained on the alternative activities. balance sheet will be diminished. The combination of infrastructure investment and accounting ramifi- Both you and institution management should review cations often makes earnings and capital growth the underwriting standards for loans originated by highly dependent on future origination volumes. third parties and the institution’s quality assurance The high volume nature of securitization along with process to verify compliance with the institution’s the accompanying investment in infrastructure (par- internal underwriting standards. Pay special atten- ticularly technology and personnel) creates an tion to issuers who securitize loans originated by incentive for management to reduce underwriting outside third parties, to ensure volume pressures do standards in an attempt to maintain origination vol- not result in systematic or uncontrolled degradation ume. This would be exacerbated in a broadly of retained and securitized asset quality. Also re- declining credit environment. view the incentive pay structure of internally generated production.

Office of Thrift Supervision September 2003 Regulatory Handbook 221.21 SECTION: Asset-Backed Securitization Section 221

Management should also plan for the risk associ- larger collection staff, facilities, systems, adminis- ated with having to reacquire “defective” trators, legal support, and capital to meet its receivables. If an issuer is active in the securitiza- servicing contractual obligations. If credit condition market and has a proven track record, the risk tions unexpectedly deteriorate, servicing costs can related to representations and warranties is likely to rise substantially, changing servicing from an asset be relatively small. In contrast, inexperienced issu- to a liability. ers and institutions with previous problems relating to representations and warranties may face greater Institutions that retain servicing in a securitization risk, warranting incrementally higher levels of capi- are vulnerable to additional pressures. The value of tal support. their residual interest in the securitization is typically based in part on the excess servicing spread. Servicing and Operational Risk To maintain the recorded value of its residual interest, the institution, as a servicer, may feel pressured Retaining the servicing on securitized portfolios can to delay recognition of delinquencies and losses in help thrift institutions increase their loans under the asset pool it services. It may do so to maintain management and achieve economies of scale in ar- the appearance that the income is there to support eas where they may have a comparative advantage the current valuation of its residual interest. due to technology, skilled personnel, and facilities. Prudent Risk Management Practices Securitization transactions are governed by detailed, lengthy, and complex contracts. Management Management should ensure that the personnel, must fully understand the institution’s servicing technology, and reserves, including capital, are in obligations under these contracts, and must have the place to support the associated transaction risks. To resources, including capital, to fulfill its obliga- reduce the institution’s exposure, management tions. should evaluate staffing, skill levels, and the capacity of systems to handle the projected type and The servicer’s primary contractual responsibilities volume of transactions. are the collection and transmittal of funds received from the underlying borrowers to the trustee and/or When contemplating and implementing uses of investors, account maintenance and recordkeeping, technology, institution management should engage performance reporting, and collection of past due in a rigorous analytic process to identify and quan- accounts. tify risks and establish risk controls to manage exposures. Before engaging in securitization, man- Servicing obligations can pose a risk to earnings agement should ensure the servicing platform and capital should the cost of servicing securitized provides timely and accurate information on both assets exceed projections or expected revenue not securitized assets and the on-balance-sheet portfo- materialize. Servicing costs and revenues are a lio. The servicing personnel and platform should be function of volume, the quality of assets being ser- compatible with new types of borrowers and/or viced, the structure of the transactions (revolving or products offered. A quality assurance process amortizing), the maturity/duration of the underlying should monitor reports regarding asset quality and assets, including the speed of prepayments, the analyze customer complaints regarding servicing technology used, the complexity of the servicing problems. process, and the ability and experience of servicing personnel. The expected growth in the volume of securitized assets and its impact on servicing capabilities Servicing subprime loans is riskier than servicing should be a critical part of long-range technology prime loans. It is easy to underestimate the high planning. Ongoing periodic reviews of system ca- cost of servicing such loans or the speed that per- pacity should consider the types of assets being forming loans will be prepaid. Subprime loans serviced (revolving vs. nonrevolving, prime vs. default more frequently than prime loans, and, as a subprime, etc.) and the expected lives of the securi- result, have far more repossessions and foreclosures tization transaction and the underlying assets. Since than prime loans. A subprime servicer must have a effective servicing platforms are heavily reliant

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upon the use of technology and information sys- Market Risk tems, management must ensure appropriate back-up systems and contingency plans are in place and Securitization can provide matched funding, and, if tested periodically. transactions are structured carefully, can be an effective means of managing market risks. Institutions Compliance Risk often hedge interest rate risk inherent in securitization transactions. However, some market Consumer laws and regulations, including fair lend- participants erroneously assume that the seller no ing and other antidiscrimination laws, affect the longer faces market risks, including interest rate underwriting and servicing practices of institutions risk, simply because the receivables are transferred even if the receivables are later securitized. There- off the balance sheet. fore, institutions do not eliminate compliance risk simply through the securitization process. Assets Depending on the structure, the excess spread re- originated for securitization purposes and those that ceived by the seller may be subject to fluctuations have been securitized should be included within the in interest rates. For example, the seller faces inter- institution’s compliance program. est rate risk when fixed rate receivables are used to support a floating rate asset-backed security. If this As previously noted, securitization lends itself to transaction is left unhedged, as interest rates rise the higher quality and diverse asset pools. Because of coupon paid to investors increases while the portfo- the need for predictable cash flows imposed by the lio yield remains constant, resulting in less excess secondary market, management may be less likely spread received by the seller. to originate loans in certain geographic areas or to borrowers below minimum income levels. Banks The seller may still be exposed to market risk even and thrifts that concentrate origination and servic- in transactions where floating rate securities are ing activities in high quality asset types may, albeit supported by floating rate receivables. The timing unintentionally, engage in “economic” redlining. and magnitude of the rate change on the asset- backed security coupon may not match the timing Prudent Risk Management Practices and magnitude of the rate change on the underlying receivables. Management of institutions that securi- Institutions should ensure that firm-wide capital tize receivables must accurately assess the source levels sufficiently compensate for the compliance and amount of market risk inherent in the structure risk associated with both on-balance-sheet assets as and ensure that its risk management processes con- well as assets originated but sold via securitiza- sider this risk. tions. Specifically, the capital allocation process and level of capital held for compliance risk related Some issuers may access the nondollar securitiza- to securitized assets should be similar, if not identi- tion market by issuing certificates denominated in a cal, to capital for compliance risk associated with foreign currency. If the underlying assets were de- on-balance-sheet receivables. Internal audits or nominated in U.S. dollars, any fluctuation in the quality control reviews for compliance should not value of the foreign currency relative to the U.S. segregate assets based upon their securitization dollar would directly affect the cash flows available status. to investors. As a result, the asset-backed securities market requires protection against potential cur- Senior management with securitization programs rency risk in the form of a currency swap. should be cognizant of the possibility of fair lending Depending upon the financial stability of the third violations and must meet the requirements of the party and the structure of the swap, the institution Community Reinvestment Act as well as the institu- may be subject to counterparty risk from the third tion’s own corporate responsibility objectives. party.

Office of Thrift Supervision September 2003 Regulatory Handbook 221.23 SECTION: Asset-Backed Securitization Section 221

Prudent Risk Management Practices performing, servicing records are incomplete, and significant operational remediation is required. Institutions that securitize receivables must accurately identify the source and quantify the amount The appointment as trustee is typically packaged of market risk inherent in each transaction. Institu- with related agency appointments of registrar, pay- tion management should monitor and control risk ing agent, and successor servicer. The trustee may levels within the context of firm-wide earnings and also be asked to perform “nontraditional” roles. economic value at risk limits. Institution-wide inter- These enhanced agency roles include calculation est rate and currency risk management processes agent, document custodian, tax reporting agent, and must consider all sources of market risk and ensure back-up servicer. that capital is adequate relative to the risk assumed. The institution’s independent credit approval proc- Because of the complexities of an asset-backed se- ess should review and approve all counterparties. curitization, the trustee is at greater risk of an operational error than on a typical capital markets Fiduciary/Trustee Risk transaction. Operational errors may include an incorrect or missed distribution, misapplication of A trustee’s main responsibility is to represent the funds between transaction participants, incorrect interest of the certificate holders, particularly dur- investment of funds, lost collateral documentation, ing an event of default, including an early and the untimely or missed notification of a signifi- amortization. Other responsibilities include moni- cant event. toring covenant compliance, authentication of the asset-backed securities, and enforcement of reme- Prudent Risk Management Practices dies during an event of default as defined in the governing document. Trustee organizations must be staffed by personnel experienced in securitization and knowledgeable of The structure of an asset-backed securitization a variety of asset types and transaction structures. transaction must be legally sound and adequately The trustee must have an effective risk control and distinguish the duties and responsibilities of the monitoring system. This includes appropriate ac- transaction parties in a clear and logical manner. count acceptance procedures, ongoing self- The trustee must be able to defend the true sale as- assessment and account review procedures, and an pect of the transaction on behalf of the security audit program. holders. The trustee must ensure that the trust maintains a security interest in the underlying assets and Qualified trustees should have experienced account that the entity status of the trust remains intact. managers with a proven record of administering similar structured transactions and a familiarity of After an asset-backed securitization closes, the trus- the specific asset type. Trust officers should be tee and the servicer are normally the only entities adequately trained in trust administration, informa- that retain ongoing contractual duties. To fulfill its tion systems, ethical business practices, and duties, the trustee is dependent on getting timely and customer service. accurate information from the servicer. A primary duty of the trustee is to assume the role of successor Trustee organizations must make significant in- servicer in the event that the original servicer is re- vestments in operational systems technology. The moved or terminated. The trustee is most likely to business requires a large operational staff to handle be required to step in as the successor servicer if the intricate securities processing requirements such there is an event of default and subsequent termina- as providing registrar and bond recordkeeping ser- tion and removal of the servicer. The successor vices, funds disbursements, and document custodian servicer ensures that collections and other cash services. flows remain uninterrupted and that distributions continue to be paid to certificate holders. When the If the trustee is the successor servicer, it must either role of servicing is transferred to the trustee or a be ready to directly assume servicing responsibili- successor servicer, the portfolio is typically under- ties or have a well-developed plan in place to transfer servicing responsibilities to a third party.

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The essential requirements for a back-up servicer Prudent Risk Management Practices include sophisticated systems, collection expertise, and an analytical staff to fulfill the servicing duties. For securitization activities, reputation risk is essentially a function of the quantity, discipline, and If the trustee serves as back-up or successor ser- commitment of the risk management practices for vicer and is unable to fulfill all or any part of the each of the areas discussed above. If an institution administrative and/or operational requirements inappropriately evaluates and manages the risk in ternally, it may engage the services of a third party other risk categories, reputation risk should be rela- vendor. The appointment of a third party vendor tively low and a comparatively lower level of does not replace the successor or back-up servicer’s capital should be needed to maintain market confi- liability or contractual obligations on the transac- dence during normal as well as stressed periods. tion; however, through the engagement of a third party vendor, some or all of the relevant administra- ACCOUNTING CONSIDERATIONS tive duties can be outsourced. Institutions should follow Statement of Financial Reputation Risk Accounting Standards Statement 140, Accounting for Transfers and Servicing of Financial Assets and Exposure to reputation risk is essentially a function Extinguishments of Liabilities (SFAS 140), for the of how well the internal risk management process is accounting treatment of securitizations of pooled working in each of the risk categories affected by consumer assets, including credit card debt, auto securitization and the manner and efficiency with loans, home equity loans and other consumer debt. which management responds to external influences SFAS 140 replaced SFAS Statement 125. on proprietary transactions. Reputation risk has a “qualitative” nature, reflecting the strength of an SFAS 140 provides accounting and reporting stan- organization’s franchise value and how other mar- dards for transfers and servicing of financial assets ket participants perceive it. and extinguishments of liabilities. These standards are based on the consistent application of a finan- Asset performance that falls short of expectations cial-components approach that focuses on legal will reflect poorly on the underwriting, servicing, control and recognizes that financial assets and li- and broader risk management capabilities of the abilities can be divided into a variety of originator. Because the asset performance of securi- components. Under this approach, after a transfer tized pools is often publicly disclosed and of financial assets, an institution recognizes the fi- monitored by market participants, securitization can nancial and servicing assets it controls and the highlight problems that were less apparent when liabilities it has incurred, derecognizes financial reported as a smaller component of overall portfolio assets for which control has been surrendered, and performance. derecognizes liabilities extinguished. SFAS 140 provides consistent standards for distinguishing The pricing of asset-backed securities in the mar- transfers of financial assets that are sales from ketplace reflects a number of factors including those that are secured borrowings. liquidity of the security, structure of the transaction and asset performance. Typically, firms perceived A transfer of financial assets in which the institu- to have strong risk management processes and tion surrenders control over those assets is demonstrate predictable historical performance are accounted for as a sale to the extent that considera- rewarded with more efficient deal execution and tion other than beneficial interests in the transferred tighter pricing over the life of the transaction. No- assets is received in exchange. The transferor has tably, institutions that are experiencing problems or surrendered control over transferred assets if and are perceived to be vulnerable to stressed conditions only if all of the following conditions are met: have seen their asset-backed securities trade with significantly wider bid-offer spreads and higher · The transferred assets have been isolated from yields. the transferor and put presumptively beyond the

Office of Thrift Supervision September 2003 Regulatory Handbook 221.25 SECTION: Asset-Backed Securitization Section 221

reach of the transferor and its creditors, even in ceivables, and dealer floor plan loans sold to a bankruptcy or other receivership. relatively long term revolving securitization trust is limited to the receivables that exist and have been · Each transferee (or, if the transferee is a quali- sold (and not those that will be sold in the future fying special purpose entity (QSPE), each pursuant to the revolving nature of the deal). Rec- holder of its beneficial interests) has the right to ognition of servicing assets is also limited to the pledge or exchange the assets (or beneficial in- servicing for the receivables that exist and have terests) it received, and no condition both been sold. constrains the transferee (or holder) from taking advantage of its right to pledge or exchange the A revolving securitization involves a large initial assets and provides more than a trivial benefit transfer of balances generally accounted for as a to the transferor. sale. Ongoing, smaller subsequent months’ transfers · The transferor does not maintain effective con- funded with collections of principal from the previ- trol over the transferred assets through either ously sold balances are each treated as separate (1) an agreement that both entitles and obligates sales of new balances with the appropriate gain or the transferor to repurchase or redeem them be- loss calculation. The recordkeeping burden neces- fore their maturity or (2) the ability to sary to comply with these techniques is quite unilaterally cause the holder to return specific onerous, particularly for master trusts. You should assets, other than through a clean-up call. consult your Regional Accountant with questions about accounting for ongoing replacement of bal- An institution recognizes transfers of assets sold, ances. records the value of servicing rights and any other assets retained, records liabilities assumed, and rec- Servicing assets and liabilities should be amortized ognizes into current income any gain or loss on the in proportion to and over the period of estimated net sale when a legal change in control is deemed to servicing income or loss. A valuation allowance is have taken place and the assets have been trans- recorded for servicing assets for the excess of book ferred to an unconsolidated vehicle such as a QSPE. amount over fair value. Servicing liabilities are reported at fair value. If a legal change in control of the assets has not taken place, generally accepted accounting princi- SFAS 140 states that a transferor may derecognize ples will classify such a transaction as a secured a liability if, and only if, either (a) the debtor pays borrowing. The assets will remain on the transfer- the creditor and is relieved of its obligations or (b) ors’ books, it must record any funds it receives as a the debtor is legally released from being the primary liability and not recognize any gain or loss. obligor under the liability, either judicially or by the creditor. SFAS 140 requires securitizers to disclose Accounting for Transfers and Servicing of information about accounting policies, value, cash Financial Assets flows, key assumptions made in determining fair values of retained interest, and the sensitivity of Institutions transferring financial assets in a securi- those fair values to changes in assumptions. The tization shall measure liabilities and derivatives statement requires securitizers to disclose (a) the assumed or incurred at fair value, if practicable. total principal amount outstanding, the portion that You should discuss the accounting with your Re- continues to be recognized, (b) delinquencies, at the gional Accountant if fair value information is end of the period, and (c) credit losses during the unavailable. Institutions shall measure servicing period for securitized assets and other managed as- assets and other retained assets by allocating their sets. previous carrying amount between assets sold and retained interest, based on their relative fair values SFAS 140 differentiates between transfers of finan- at the date of transfer. cial assets where the transferor has no continuing involvement with the transferred assets or with the Gain or loss recognition for relatively short term transferee, and transactions where the transferor receivables such as credit card balances, trade re- has some continuing involvement with the assets or the transferee, including recourse, servicing, agree-

221.26 Regulatory Handbook September 2003 Office of Thrift Supervision SECTION: Asset-Backed Securitization Section 221

ments to reacquire the assets, options written or Institutions should estimate fair value based on the held, and pledges of additional collateral. The best information available when quoted market seller’s continuing involvement raises questions prices are not available, considering prices for simi- about whether a sale has actually taken place or if lar assets and liabilities and the results of any the parties to the transaction should account for it available valuation techniques. Examples of valua- as a secured borrowing with pledge of collateral. tion techniques include the present value of estimated cash flows, option-pricing models, matrix Recognition and Measurement of Servicing pricing, option-adjusted spread models, and funda- Assets and Liabilities mental analysis.

An institution as a seller must recognize either a The seller should record those assets at zero when it servicing asset or servicing liability for each servic- is not practical to estimate fair value of assets. The ing contract when it undertakes an obligation to seller should recognize no gain on the transaction service loans. when it is not practical to estimate the fair value of liabilities and should record those liabilities at the An institution must initially measure servicing as- greater of: sets or liabilities that have been purchased or assumed at fair value. Fair value is presumed to be · The excess, if any, of the fair value of assets the price paid. Servicing assets should be amortized obtained less the fair value of other liabilities in proportion to and over the period of estimated net incurred, over the sum of the carrying value of servicing income. Servicing liabilities should be the assets transferred. amortized in proportion to and over the period of · The amount that would be recognized in accor- estimated net servicing losses. Servicing assets dance with SFAS No. 5, Accounting for should be assessed for impairment based on fair Contingencies, as interpreted by SFAS Inter- value. Servicing liabilities should be carried at fair pretation No. 14. value. Effective Date Assets Subject to Prepayment SFAS 140 is effective for transfers and servicing of Interests in securitizations, such as interest-only financial assets and extinguishments of liabilities strips, residuals, seller’s or retained interest, occurring after March 31, 2001, and for recognition tranches or other financial assets that can contrac- and reclassification of collateral for fiscal years tually be prepaid or settled in a manner that the ending after December 2000. holder would not recover substantially all of its recorded investment, should be valued at fair value CAPITAL CONSIDERATIONS and classified as available-for-sale or trading in accordance with SFAS 115, Accounting for Certain OTS’s capital regulation places strict limits on the Investments in Debt and Equity Securities. amount of high risk credit-enhancing residuals a savings institution may hold in addition to a dollar- Fair Value for-dollar capital requirement for all residuals.

The fair value of an asset or liability is the amount The term “recourse” refers to an institution’s reten- at which that asset or liability could be bought or tion, in form or in substance, of any credit risk sold, incurred or settled, in a current transaction directly or indirectly associated with an asset it has between willing parties (that is, not part of a forced sold. A recourse obligation typically arises when an sale or liquidation). A quoted market price in an institution transfers an asset in a sale (a sale active market is the best evidence of fair value and according to generally accepted accounting princi- should be used as the basis for measuring fair ples) and retains an obligation to repurchase the value, if available. asset or to otherwise absorb losses on the asset. Examples of recourse obligations include:

Office of Thrift Supervision September 2003 Regulatory Handbook 221.27 SECTION: Asset-Backed Securitization Section 221

· Assets sold under an agreement to repurchase. · An institution must hold dollar-for-dollar risk- based capital for most residual interests – that · Credit-enhancing representations and warran- is, one dollar of capital for every one dollar of ties related to sold assets. residual interests. · Retained loan servicing with an agreement un- · In addition to the dollar-for-dollar risk-based der which the savings association is responsible capital requirement for a residual, if the asset for losses associated with the loans serviced, also meets the definition of credit-enhancing in- with the exception of Servicer Cash Advances terest-only strip (a subset of residual interest), as defined. See 12 CFR §567.1. then the institution must deduct from core capi- · Clean-up calls on assets sold (except for clean- tal (that is, tier 1 leverage capital), the amount up calls that are 10 percent or less of the origi- of credit-enhancing interest-only strips that ex- nal pool balance and that are exercisable at the ceed 25 percent of core capital. option of the savings association). · A ratings based approach allows an institution · Credit derivatives that absorb more than the to reduce its capital requirement for lower risk, institution’s pro rata share of losses on trans- highly rated recourse exposures (including di- ferred assets. rect credit substitutes and residual interests, but excluding credit-enhancing interest-only strips). · Loan strips sold where the maturity of the transferred portion of the loan is shorter than · The capital treatment for most recourse expo- the commitment under which the loan is drawn. sures is “gross-up,” whereby an institution must hold capital for the full amount of the Recourse can also be implicit. Implicit recourse transferred assets as if they were still on the generally arises when a thrift institution repurchases balance sheet. assets, absorbs losses, or otherwise supports assets that it has sold, in instances where it is not contrac- There is an exception to this treatment for qualify- tually required to do so. ing mortgages (1-4 Family Loans that would receive a 50 percent risk weight) that a thrift An institution can guaranty, purchase, or assume a institution has sold, if the sales contract allows only recourse exposure from another organization. These a 120-day return period. The loans must have been exposures are referred to as direct credit substi- originated within one year prior to sale. tutes. A purchased subordinated security is an example of a direct credit substitute. There is also an exception to the gross-up treatment for low-level recourse exposures where recourse is Recourse exposures can also take the form of resid- legally and contractually limited to an amount less ual interests. However, residual interests are than the on-balance-sheet capital requirement. typically on-balance-sheet assets, in contrast to the above examples of recourse exposures that are off- For additional material on capital requirements for balance-sheet. Residual interests have credit risk residual interests, recourse, and direct credit substi- that exceeds a pro rata share of the total credit risk tutes, refer to Appendix B of this Section, and to 12 on the transferred assets. A retained CFR §567.1 (definitions) and §567.6 (risk on-balance-sheet first loss piece of a securitization weights). is an example of a residual interest. Other examples include spread accounts, cash collateral accounts, SUPERVISORY FOCUS and credit-enhancing interest-only strips. While OTS generally believes that securitization Capital Requirements can be beneficial to thrift institutions, it must be done in a safe and sound manner. To do so, the in- There are special capital requirements for recourse stitution must identify, measure, manage, and exposures and residual interests: control the associated risks as outlined in this Handbook Section. In particular, examiners should scrutinize high risk lending activities done through

221.28 Regulatory Handbook September 2003 Office of Thrift Supervision SECTION: Asset-Backed Securitization Section 221

securitizations that the institution would not or plement policies and procedures that include limits could not undertake directly. on the amount of residual interests that may be carried as a percentage of capital. We are also concerned with inappropriate valuation techniques that an institution might use to value its The Guidance states that critical components for an retained interests. Such valuations must be fully effective oversight program include the following: documented, based on reasonable assumptions, and regularly analyzed for any subsequent change in · Independent risk management commensurate performance and resulting value impairment. with the complexity of the securitization activities. The best evidence of fair value is a quoted market · Comprehensive audit and loan review coverage. price in an active market. If unavailable, fair value may be estimated. Such estimates must be based on · Appropriate valuation and modeling method- reasonable, supportable, and currently valid as- ologies. sumptions. If an estimate of fair value is not · Accurate and timely risk-based capital over- practical, the asset should be recorded at zero in sight. financial and regulatory reports. · Prudent internal limits to control the amount of Unforeseen market events that affect performance equity capital at risk. of loans supporting a retained interest can quickly alter its value. Without appropriate internal controls Supervisory Focus and independent oversight, an institution that securitizes assets may inappropriately generate In preexamination planning as well as in conducting “paper profits” or mask actual losses through onsite work, you should focus your attention on flawed loss assumptions, inaccurate prepayment institutions, and areas within institutions, that have rates, and inappropriate discount rates. Liberal and unproven personnel, unfamiliar risk management unsubstantiated assumptions can result in material systems, and riskier activities. Higher risk assets inaccuracies in financial statements, and subsequent and rapidly growing activity volumes often translate write-downs of retained interest. If such interest into more challenging origination, processing, col- represents a substantial portion of the institution’s lection, reporting, and oversight responsibilities. capital, such devaluations could result in the failure Supervisory expectations for risk management of the institution. practices and capital coverage should be propor- tional to the level and duration of the risks from the Regulatory Requirements and Guidelines on underlying assets, as well as the growth rate of Securitization business activities.

In response to the increased use of securitizations You should determine whether the institution’s se- by institutions, the banking agencies published the curitization activities are conducted in a safe and Interagency Guidance on Asset Securitization in sound manner and in accordance with the Securiti- December 1999 (Securitization Guidance), which zation Guidance mentioned above as well as OTS addressed supervisory concerns with risk manage- capital regulations. You should also compare the ment and oversight of these securitization asset performance of outstanding securitizations to programs. (See Appendix A.) The Securitization industry benchmarks on both a spot and trend basis. Guidance highlighted the most significant risks as- In evaluating an institution’s securitizations relative sociated with asset securitization, emphasized to the industry, you should consider factors related concerns with certain residual interests generated to the risk, valuation, and the pricing of the underly- from the securitization and sale of assets, and set ing assets. forth fundamental risk management practices that the agencies expect institutions that engage in secu- If either the risk or pricing of those assets is out of ritization activities to implement. In addition, the balance, then a smaller than normal excess spread Guidance stressed the need for management to im- would be a signal of higher risk to the institution. Credit spreads in the capital markets can also pro-

Office of Thrift Supervision September 2003 Regulatory Handbook 221.29 SECTION: Asset-Backed Securitization Section 221

vide signals on which institutions and individual Code of Federal Regulations (12 CFR) securities are underperforming. Chapter V: Office of Thrift Supervision Rating agencies will typically require greater levels of credit enhancement based on the structure of the § 560 Lending and Investment securitization, the expected performance of the un- § 560.30 General Lending and Investment derlying assets and the experience of the issuer. Powers You should evaluate and understand the difference in subordination levels required by the ratings agen- § 560.101 Real Estate Lending standards cies across issuers of similar assets, structures and § 561.19 Financial Institutions securities. You should focus on institutions and § 563.41 Loans and Other Transactions transactions that have material adverse variances with Affiliates and Subsidiaries from benchmarks. During the examination process, § 563.43 Restrictions on Loans, Other determine the reason(s) for adverse performance, Investments, and Real and Per- security structures, and/or pricing. Ensure man- sonal Property Transactions agement is taking appropriate actions to control the Involving Affiliated Persons situation, and that capital is adequate for the risk. § 567 Capital Requirements

You should review the institution’s valuations of and controls over securitization activities. When Joint Agency Issuances you identify inappropriate valuation assumptions, weak risk management practices or lax internal con- Interagency Guidance on Asset Securitization Ac- trols, you should direct the institution to take tivities – December 13, 1999 (Attachment A). immediate corrective action. In situations where the institution cannot provide objective and verifiable Interagency Guidance on Capital Treatment for support for the valuation of retained interests, you Recourse, Direct Credit Substitutes, and residual should classify the assets Loss and disallow them as interests – November 29, 2001 (Appendix B). an asset for regulatory capital purposes. Interagency Questions and Answers on the Capital Treatment of Recourse, Direct Credit Substitutes, REFERENCES and Residual Interests in Asset Securitizations – May 23, 2002. United States Code (12 USC) Interagency Advisory on the Unsafe and Unsound Chapter 2: National Banks Use of Covenants Tied to Supervisory Actions in Securitization Documents – May 23, 2002. § 84 Lending Limits Interagency Guidance on Implicit Recourse in Asset Home Owners’ Loan Act Securitizations – May 23, 2002.

§ 1464 (c) Investment Authority Interagency Guidance on the Regulatory Capital § 1468 Transactions with Affiliates and Treatment of Accrued Interest Receivable Related Loans to Insiders to Credit Card Securitizations – May 17, 2002.

Federal Deposit Insurance Act

§ 1813 Definitions § 1831e Activities of Thrifts

221.30 Regulatory Handbook September 2003 Office of Thrift Supervision SECTION: Asset-Backed Securitization Section 221

Interagency Advisory on the Accounting Treatment of Accrued Interest Receivable Related to Credit Card Securitization – December 4, 2002.

Accounting Issuances

Financial Accounting Standards Board

Statement of Financial Accounting Standards No. 140, September 2000.

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