Alert May 05, 2009

FDIC Issues Guidance on Risk Management of Investments in Structured Credit Products

The FDIC issued a Financial Institution Letter, FIL-20-2009 (the “Letter”) concerning risk management of investments in structured credit products.  The FDIC said that the Letter is intended to reiterate and clarify existing supervisory guidance concerning a bank’s purchase and holding of complex structured credit products, e.g., mortgage-backed securities, collateralized debt obligations and asset-backed securities.

The Letter stresses that risk management of investments in structured credit products requires a thorough pre-purchase due diligence process, reasonable exposure limits, “accurate risk measurement, an understanding of the tranched structure, knowledge of the collateral performance, and a determination of investment suitability.”  In evaluating a potential investment in a structured credit product a bank should consider not only credit ratings, but other factors, including whether the security in which the bank seeks to invest is subordinate to more senior tranches of the applicable securitization structure.  Furthermore, the bank should consider the market risk, liquidity risk and operational risk associated with the proposed investment.

The Letter further states that a bank should be certain that the bank’s internal risk management and reporting systems are “tailored to the risk profile of the investment portfolio.”  Moreover, the Letter states that a bank should have a “reasonable, documented and consistently applied approach to pricing high‑risk, illiquid, complex structured credit products.”

The FDIC also states that bank examiners’ classifications of structured credit products will continue to be governed by the 2004 Interagency Uniform Agreement on the Classification of Assets and Appraisal of Securities.  The Letter notes that under the Uniform Agreement bank examiners may adversely classify an investment in a structured credit product even though the investment bears an investment grade credit rating.  Finally the Letter discusses capital treatment of investments in structured credit products.