William Stark (202) 898-6972
Curtis Wong (202) 898-7327
Michael J. Zamorski
Examination Treatment for Certain Types
of Credit-Linked Notes
1. Purpose. To explain the examination treatment of a new type of credit-linked note under current supervisory policy.
2. Background. Credit-linked notes are debt securities that contain embedded credit derivatives. Due to the embedded credit derivative, a credit-linked note is a form of structured note. Credit-linked notes facilitate the transfer of the credit risk associated with a reference asset from a counterparty to the buyers of the notes. Commercial loans and corporate bonds are the most common types of reference assets.
While credit-linked notes have been issued since the mid-1990s, some insured institutions have recently purchased a new type of credit-linked note with speculative characteristics. This new instrument pays investors two distinct and unrelated cash flows: 1) a principal payment at maturity, typically 12 years, equal to the par value of the security, and 2) quarterly interest payments tied to the performance of a below investment grade asset-backed residual.
From an economic perspective, the purchase price of the credit-linked note can be decomposed into two separate payment amounts: one amount for the principal cash flow at maturity and one amount for the uncertain stream of future interest payments. In some cases, the payment amount for the uncertain interest cash flows may represent over 50% of the total purchase price of the credit-linked note. The principal cash flow is similar to a zero coupon bond, while the interest cash flows resemble an interest-only strip.
The principal cash flow at maturity is guaranteed by a highly rated counterparty. The interest cash flow is not guaranteed, and payments are based solely on the credit performance of the below investment grade asset-backed residual. If the credit quality of the assets underlying the residual severely deteriorates, investors may receive little or no interest on their securities. An investor that purchases a credit-linked note at par, holds the security to maturity, and receives only the guaranteed principal cash flow would earn a zero percent rate of return over 12 years. Given the cost that an insured institution would incur to carry the investment until maturity, this scenario would result in foregone earnings for the 12-year holding period.
Under certain conditions, the credit-linked notes may be redeemed prior to their stated maturity date. In the case of early redemption, the investor is paid the discounted present value of principal payment plus the fair value of the asset-backed residual. The total of these two payment amounts may be less than the investor's initial cash outlay when purchasing the credit-linked note.
While these securities have been marketed as "principal protected" investments due to the guaranteed principal cash flow at maturity, they are speculative in nature and are unsuitable for most insured institutions. Further details regarding the characteristics and risks of these securities are provided in the appendix to this memorandum.
3. Supervisory Policy. The interagency 1998 Supervisory Policy Statement on Investment Securities and End-User Derivatives Activities contains risk management standards for the investment activities of insured institutions. For securities with high risk profiles, such as the credit-linked notes described in the previous section, management is expected to thoroughly analyze the instruments prior to purchase. Before investing in these products, management should consider the following questions, consistent with regulatory policy:
Are the securities legally permissible investments for the institution, given the below investment grade quality of the reference asset?
Are the securities allowable investments under the institution's policies?
Is the investment within the bank's internal concentration limit for structured notes?
Does management understand the cash flow characteristics and risks of the securities?
Has management conducted a comprehensive, independent pre-purchase analysis of the securities, including all components of the deal structure?
Has the institution determined that it can effectively monitor and manage the risks associated with the securities?
Has management considered the effect of the securities on the investment portfolio as a whole and the overall interest rate risk position of the institution?
Management should maintain documentation to demonstrate that its investment decisions are consistent with the sound practices set forth in the policy statement. Subsequent to purchase, management should periodically monitor the performance of the securities and maintain adequate records of this ongoing review.
4. Examination Treatment.
Unsuitable Investment Activities
It is an unsafe and unsound practice for an insured institution to purchase securities without having a full understanding of the risks of the instruments and demonstrating the ability to manage these risks. Security purchases that do not meet these supervisory standards should be cited as unsuitable investment practices in the Report of Examination. Examiners should consider these weaknesses when assigning the bank's component and composite CAMELS ratings and determining the need for corrective action. Institutions with material exposure to high-risk securities may be required to hold additional capital.
The Securities and Derivatives Chapter of the DOS Manual of Examination Policies contains examination guidance regarding the classification of securities. According to this section of the manual, securities that do not meet the definition of investment quality should be classified under the Uniform Agreement on Classification of Assets and Appraisal of Securities Held by Banks.
While this new type of credit-linked note will typically carry a high investment grade rating as to the ultimate repayment of principal at maturity, the rating does not apply to the interest cash flows. For classification purposes, examiners should divide the institution's carrying value into two categories: an interest only (IO) portion and a principal only (PO) portion. The PO portion can be calculated by determining the discounted present value of the principal cash flow as of the examination date, using the formula in the prospectus for early termination. It has been our experience that the early termination calculation will produce a reasonable proxy of market value for the PO portion. The IO portion can be estimated by subtracting the PO portion from the carrying value of the security, including any accrued interest. For example, if the bank's carrying value including accrued interest is $1,010,000, and the present value of the PO is $450,000, then the IO portion of the investment would be the difference of $560,000.
For credit-linked notes where the IO portion is tied to a reference asset that meets the definition of a sub-investment quality security, the IO portion should be classified as outlined in the manual. The severity of the classification would largely be determined by the degree of risk and cash flow uncertainty of the reference asset. Factors that may be considered include the quality of the collateral underlying the reference asset, the extent to which the reference asset's credit risk is leveraged, the degree of subordination in the reference asset, the actual performance of the collateral, and the reasonable expectation of future collateral performance. To the extent that the principal cash flow is backed by an investment grade quality counterparty, the PO portion would not be subject to adverse classification.
5. Action Required. This document should be distributed to all examiners
Credit-Linked Notes with Residuals as Reference Assets
The credit-linked notes (CLNs) are issued by a bankruptcy-remote special purpose vehicle (SPV) and offered through a private placement memorandum. The collateral for the CLNs is a type of credit derivative known as a total return swap. The reference asset for the swap is a residual note issued by a separate special purpose vehicle. The residual note is a subordinated class of a collateralized loan obligation (CLO).
The CLNs are issued as private placement securities under SEC Rule 144A. The terms of the CLNs include an issue price close to par; face amount payable at maturity; stated maturity of 12 years; and stated interest rate of Libor plus a spread. While the CLNs carry a stated interest rate, the quarterly interest payments will be based solely on the performance of the reference asset. The principal cash flow of the CLNs is rated AAA by a major rating agency based on the creditworthiness of the swap counterparty. The interest cash flow is not rated.
The swap counterparty receives an up-front principal payment from the SPV equal to the proceeds from the issuance of the CLNs. In return, the swap counterparty is obligated to make a principal payment at the maturity date or early termination date and to make quarterly interest payments that mirror cash flows generated by the reference asset. The payments made by the swap counterparty are passed through to investors by the SPV. If no cash flow is generated by the reference asset for a particular payment date, the swap counterparty is not obligated to make an interest payment to the SPV.
In the case of early termination, the swap counterparty is obligated to pay the SPV the present value of the par amount of the securities, discounted from the final maturity date to the early termination date, plus the market value of the reference asset. The SPV would be expected to trigger the early termination provisions of the swap if the reference asset stops producing cash flows prior to the final maturity date of the CLNs or if the counterparty defaults on the contract.
The Reference Asset
The reference asset for the swap is a CLO residual. The final maturity date of the residual will be near the final maturity date of the CLNs. The residual class is fully subordinated to the senior notes in the CLO structure and other expenses payable by the SPV. In addition, certain protection triggers for the benefit of the senior note holders may further limit the amount of cash flow available to the residual.
The CLO Structure
The CLO issues multiple classes of securities, each with a different priority to receive the cash flows from the underlying collateral. Unlike most asset-backed securities, the collateral underlying is a CLO is actively managed by an independent investment advisor in accordance with pre-determined asset allocation guidelines. The majority of permitted investments are senior secured bank loans and high-yield corporate debt securities; however, small amounts of credit-linked notes and credit derivatives may also be acquired. The average credit quality of the collateral will be below investment grade. The CLO will have a reinvestment period of up to seven years, during which time principal proceeds from the redemption, maturity, or sale of collateral will be reinvested in new assets. Following the reinvestment period, principal payments from the underlying collateral will be passed through in order of priority to the CLO classes.
Credit losses on the underlying collateral are first charged against the cash flow to the residual. The residual's future cash flows would have to be completely eliminated before losses would be allocated to the senior classes. While the residual class typically accounts for only 10% of the total CLO, it absorbs credit losses for 100% of the collateral. Given that the residual assumes more than its pro-rata share of credit losses, it is exposed to leveraged credit risk on a pool of below investment grade assets. Performance triggers also are established within the CLO structure to protect the senior classes. These triggers generally divert cash flows away from the residual to increase the cash flows available to the pay principal and interest to the senior classes, if the credit losses on the underlying collateral exceed certain levels.
The primary risks of CLNs are credit risk and liquidity risk. Given the Aaa rating of the principal cash flow, the primary credit risk stems from the uncertain interest cash flows, which are tied to the performance of a below investment grade residual. Higher than expected losses on the collateral underlying the CLO will reduce the cash flows to the residual, and in turn, reduce the interest cash flows to the CLNs. The credit risk is magnified by the high degree of leverage built-in to the residual. The CLNs are privately placed securities for which no known secondary market exits. Their liquidity is likely to be extremely limited.