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Saturday, October 10, 2015

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Update Newsletter: Winter 2004 – Special Conference Issue

Examiners' View of Credit Card Asset-Backed Securities

The last session of the day introduced participants to measures that bank supervisors are taking to address balance-sheet risks associated with asset-backed securities (ABS). Kathryn Dick, Office of the Comptroller of the Currency, served as moderator for the panel, which included Kelly Ballard, Office of the Comptroller of the Currency; David Kerns, Board of Governors of the Federal Reserve System; Keith Ligon, Federal Deposit Insurance Corporation; and Richard Westerkamp, Federal Reserve Bank of Richmond. The panelists offered their perspectives of how regulators are addressing new risks posed by ABS.

Ligon provided a baseline for the discussion by reviewing the relationship between ABS issuance and recent bank failures. He noted that although only four of the 34 banks that failed between 1997 and 2002 issued ABS, losses at those four banks amounted to $1.7 billion, or 78 percent of the total losses accruing to the FDIC during that period. Loss rates at those banks were the highest among the 34 failures, averaging well over 50 percent. Hence, the difficulties associated with banks’ issuing ABS, although few in number, have been costly.

Drilling deeper into these cases, Ligon noted that in addition to these banks’ overreliance on securitization as a funding source, other warning signs were also often present, including large amounts of brokered deposits, high-growth business strategies, and poor corporate governance.

Brokered deposits are known to be related to large loss rates even in banks that do not securitize because brokered deposits are usually added to satisfy funding needs of high-growth institutions and can present moral hazard concerns. Brokered deposits are "hot money," often paying above market rates to rate-sensitive customers, and they can be withdrawn from the institution at the first sign of trouble.

High-growth business strategies contribute to losses because the aggressive business models used by these banks relied crucially upon aggressive accounting — adhering to the letter rather than the principles behind accounting rules. An important component of failed bank losses in the early part of the 1997-2002 period was “gain-on-sale” accounting, wherein valuation gains on the residual were required to be booked at the time of the sale (even though cash flows arising from these purported gains may lie far in the future). Sometimes managers not only distorted but also concealed information to meet financial targets, hoping the firm could “grow out” of its problems.

Failed banks issuing ABS usually demonstrated poor corporate governance practices. Those failed banks often lacked independent directors, showed evidence of weak internal controls, and often wielded de facto control over third-party vendors.

As a result, failed banks that issued ABS often became repositories of “toxic waste”: high-risk residual interests. Failed banks often valued these risky investments using scenarios that included aggressive cash flow assumptions, with especially unrealistically low pool losses. In two well-publicized cases, these residuals were a major component of bank capital at the time of failure, totaling over 634 percent of tangible capital for Keystone and almost 400 percent of core capital (over 2,000 percent of tangible capital) for Superior.

As discussed previously, risky business models based on securitization as a major funding conduit are easily manipulated. As such, the panel participants noted that all of the bank supervisory agencies emphasize the need for a proactive focus and quick action when improprieties are first detected.

In response to the difficulties and actual losses experienced so far, examiners from the four major bank regulatory agencies have developed a flexible system of coordination to deal with fast-moving policy developments related to ABS. An interagency working group now convenes at least once a month to focus solely on ABS surveillance policy. Furthermore, this working group has developed a number of interagency guidance documents that are less formal than regulatory rules but effective in addressing new risks quickly as they become evident. The interagency working group has developed guidelines applicable to accrued-interest receivables, interpretations of implicit recourse, and covenants tied to supervisory actions in securitization documents. The group has weighed in on the proposed rulemaking for additional capital standards for early amortization.

The bank supervisory community will also be responsible for monitoring compliance with Basel II capital requirements, as discussed in a panel earlier in the day. In this regard, Basel II is just the “C” in CAMELS, and regulatory risk-based capital measurements are minimums. Hence, there is still a lot of work to be done evaluating bank ABS risks and enforcing compliance related to ABS issuance and related investments, which, in the end also includes risky business models, funds concentration, and other risk factors noted earlier.