The FDIC released a financial institutions letter yesterday reiterating and clarifying existing supervisory guidance on the purchase and holding of complex structured credit products. Noting that “insured banks with portfolio holdings in private label mortgage-backed securities, collateralized debt obligations (CDOs), or asset-backed securities (ABS) are facing heightened losses,” the FDIC sought to emphasize the existing guidance for institutions’ investments in such products. In particular, the letter outlined guidance under the following five categories: (i) “Investment Suitability, Concentrations and Due Diligence,” (ii) “Use of External Credit Ratings,” (iii) “Pricing and Liquidity,” (iv) “Adverse Classification of Investment Securities” and (v) “Capital Treatment and Adequacy.”
Under the first category, “Investment Suitability, Concentrations and Due Diligence,” the FDIC emphasized the importance of employing adequate research and surveillance staff in the context of investing in and monitoring complex structured investment products. Noting the importance of risk diversification, the FDIC encouraged institutions to undertake the appropriate due diligence of the investments as well as the risks inherent in the industries relating to the underlying collateral. The FDIC also emphasized the importance of understanding the mechanics of the payments in structured products as well as the performance of the underlying collateral on a deal- and pool-wide basis.
Under the second category, “Use of External Credit Ratings,” the FDIC articulated the position that, for many industry professionals and regulatory bodies, is becoming something of a mantra – that institutions should consider investment ratings but not solely rely on them as a factor in determining the institution’s investment strategy. Noting that rating agencies may not always accurately assess the underlying credit (and other) risks associated with a particular structured product, such ratings should not be considered an adequate substitute for an institution’s own due diligence.
Under the third category, “Pricing and Liquidity,” the FDIC discussed the importance of understanding the valuation models and methodologies associated with price discovery of illiquid assets, as most structured products have very limited secondary markets. The FDIC also emphasized the importance of understanding the fair value accounting rules, noting that the required valuation methodologies affecting an institution’s structured products investments would have a significant impact on the institution’s bottom line.
Under the fourth category, “Adverse Classification of Investment Securities,” the FDIC outlined the circumstances under which examiners may depart from general ratings guidance to assign adverse classifications to securities held by depository institutions. In addition, the FDIC emphasized that examiners should not limit adverse classifications to strictly credit analysis, but rather should address a variety of factors, such as investment suitability, risk management, liquidity risk exposure and unrealized depreciation in ascertaining whether an adverse classification is warranted.
Finally, under the fifth category, “Capital Treatment and Adequacy,” the FDIC outlined the general risk-based capital standards that allow institutions to assign risk weights to structured products based on external credit ratings. The FDIC also noted the importance in distinguishing between senior and subordinated tranches in making such assignments.
In general, the FDIC articulated the hope that appropriate identification and management of risks in structured products would result in a decrease in other-than-temporary impairment charges and fair value markdowns.