|BOARD OF GOVERNORS
FEDERAL RESERVE SYSTEM
WASHINGTON, D. C. 20551
|DIVISION OF BANKING
SUPERVISION AND REGULATION
May 23, 2002
Recent examination reviews of documentation governing securitization transactions have uncovered covenants that use adverse supervisory actions or the breach of supervisory thresholds as triggers for early amortization events or the transfer of servicing. Examples of supervisory actions include a downgrade in the organization's CAMELS rating, an enforcement action, or a downgrade in a bank's prompt corrective action capital category. The inclusion in securitization documents of supervisory-linked covenants will be considered by the federal banking agencies as an "unsafe and unsound banking practice" that undermines the objective of supervisory actions and thresholds. An early amortization or transfer of servicing triggered by such events can create or exacerbate liquidity and earnings problems for a banking organization that may lead to further deterioration in its financial condition.
On May 23, 2002, the federal banking agencies issued guidance alerting banking organizations' management and boards of directors to the safety and soundness implications of certain covenants included in securitization documents. A copy of the guidance is attached.
Convenants that contain triggers tied, directly or indirectly, to supervisory actions or thresholds can result in the early amortization of a securitization at a time when the sponsoring organization's ability to access other funding sources is limited. The early amortization of a securitization's bonds can cause investors to lose confidence in the stability of the sponsoring organization's asset-backed securities, limiting its ability to raise new funds through securitization. At the same time the organization must fund new receivables on balance sheet, potentially resulting in liquidity problems. Moreover, the existence of a supervisory-linked trigger potentially could inhibit supervisors from taking action intended to address problems at a troubled institution because they could trigger an event that worsens an institution's condition or causes its failure.
The Federal Reserve and the other federal banking agencies are further concerned that covenants related to supervisory actions may obligate a banking organization's management to disclose confidential examination information, such as the CAMELS rating. Disclosure of such information by a banking organization's directors, officers, employees, attorneys, auditors, or independent auditors, without explicit authorization by the institution's primary regulator, violates the agencies' information disclosure rules and may result in follow-up supervisory actions.
A banking organization's management should ensure that documents governing securitizations it sponsors do not include any covenants related to supervisory actions or thresholds. Effective immediately, the use of covenants that provide for the early amortization of a securitization or compel the transfer of servicing as a result, directly or indirectly, of the occurrence of a supervisory action or event will, under appropriate circumstances, be criticized as an unsafe and unsound banking practice. Moreover, banking organization management is encouraged to amend, modify, or remove these covenants from existing transactions. Any impediments a banking organization may have to taking such actions should be documented and discussed immediately with its Reserve Bank.
This letter and the attached guidance should be distributed to state member banks, bank holding companies, and foreign banking organizations supervised by the Federal Reserve that securitize assets. If you have any questions regarding this guidance, please contact Tom Boemio, Senior Supervisory Financial Analyst, (202/ 452-2982), or Anna Lee Hewko, Senior Financial Analyst, (202/ 530-6260).
Attachment (254 KB PDF)
SR letters | 2002