Financial Update (First Quarter 2002)
Securitization: New Data Reveal Exposures, Help Regulators
by Michael Padhi, senior economic analyst
he failure in July 2001 of Superior Bank FSB of Hinsdale, Ill., a thrift with $2.3 billion in assets, cost the Federal Deposit Insurance Corp. (FDIC) between $450 million and $550 million. In testimony prepared for the U.S. Senate Committee on Banking, Housing, and Urban Affairs, former FDIC Acting Director John Reich identified the reason for Superior Bank’s failure primarily as “the decision of its board and management to book high levels of retained interests related to securitization.” Reich continued, “Since 1988, failures of institutions with risk characteristics similar to those of Superior have cost the FDIC insurance funds more than $1 billion.”
“Securitization” is the transformation of assets such as loans and leases into securities that can be traded in a secondary market; commercial banks increasingly are using securitization as a tool for managing their balance sheets. Though the government-subsidized mortgage securitization market has flourished for decades, banks have more recently begun to securitize many other asset types. A primary advantage of securitization to banks is improved liquidity.
Securitization activities at a handful of banks have been mismanaged, leading to failures such as Superior Bank’s and bringing about changes in regulations and reporting requirements. To prevent further failures, federal bank regulators issued new guidelines on Nov. 29, 2001, on the capital treatment of various bank exposures such as retained interests in asset securitizations. In addition, banks are now required to report their exposures to securitization and asset sale activities in a new schedule of the bank Consolidated Reports of Condition and Income (Call Reports).
How securitization works
An ABS represents an ownership interest in the pool. A servicer, often the bank that originated and sold the asset, is contracted by the special-purpose entity to collect payments on the loans or leases in the pool of assets, to transfer funds to the investors and to foreclose if necessary.
Investors in ABSs normally require an assurance that payments are timely and are protected against credit risk. These credit enhancements on ABS issues may be provided by the bank or a third party. A retained interest (residual) is a type of credit enhancement that is included in the bank’s balance sheet. This type of enhancement provides rights to the remaining interest payments received after all investors are paid, losses are covered and servicers are remunerated.
What can go wrong
Until recent regulatory changes were made, banks were required to hold the same amount of capital against a securitized asset as against one kept on a bank’s books. Retained interests can be particularly problematic for banks because their values are difficult to calculate. Banks rely on many assumptions, such as expected default rates, that can prove to be inaccurate. Since these residuals, called retained interest-only strips, are reported on a bank’s balance sheet, they overstate the bank’s book value if they are overvalued.
New data show exposures
As table 1 shows, 281 out of 8,090 commercial banks had credit exposures to securitized assets as of September 2001. The maximum degree to which these banks’ capital levels are exposed to securitized assets’ credit risks is mostly very low. Almost half, in fact, report a credit exposure of less than 5 percent of their capital. However, six banks reported credit exposures to securitized assets in excess of 100 percent of capital. All of these entities’ exposures were to mortgage securitizations.
Overall, total credit exposure to home mortgage loans (35 percent) made up the largest portion of total securitization credit exposure, exposure to securitized commercial and industrial loans was second (29 percent), and exposure to securitized credit card receivables was third (17 percent) (see table 2.)
These tables summarize only a small portion of the total data reported by banks on the new Call Report schedule, and no conclusions on overall safety and soundness can be drawn here from the amount of exposure these institutions have relative to their capital levels.