The Federal Deposit Insurance Corp. (FDIC) recently finalized its Safe Harbor that protects the assets that are transferred to bank-sponsored securitization vehicles from a financial institution's FDIC receivership.

The rating agencies had previously said that the proposed rule had provisions that were hard to comply with, making it uncertain whether the Safe Harbor would be applicable if a bank were to fail.

Analysts at Standard & Poor's, for instance, had expressed their reservations about the stay and repudiation risks attached to security interests in terms of a bank's insolvency.

"The FDIC's final rule addressed the repudiation and stay risks to a degree such that S&P will be able to de-link the ratings, and transactions can receive triple-A ratings while complying with the conditions under the final rule," said Michael Binz, a managing director at S&P.

In a report on the rating implications of the final Safe Harbor rule, S&P said that stay risk would usually introduce potential default risk that is commensurate with the bank's rating.

This risk starts when the FDIC becomes the receiver or conservator and interrupts the payments from the institution's assets for up to 90 days from the FDIC's appointment, unless the agency consents to making these payments. The FDIC addressed the risk in the final rule by stating that the FDIC is agreeing to continue the payments required by the securitization documents or the agency, acting as a servicer, shall be making the payments.

In terms of the repudiation risk, the FDIC as a receiver can, through its statutory power, repudiate an insolvent bank's contracts, which can also introduce default risk in line with the institution's rating. This kicks in if the remedies available to the investors were not adequate to pay the rated debt in full or maintain timely interest payments.

S&P believes that the final rule mitigates the repudiation risk, since the FDIC could pay within 10 business days of the repudiation notice damages equal to the securitized principal outstanding as well as accrued and unpaid interest through the date of repudiation in an amount up to the extent collected on the assets.

"The question was whether or not the FDIC will pass along the cash flow collected during the 10-day period to the extent self-help remedies were exercised, and based on our conversations with them they would," said Felix Herrera, a managing director at S&P.

Furthermore, he explained that "because the FDIC has stated in the final rule that cash flows collected prior to repudiation would be passed along to investors, the concern raised previously by S&P of making timely interest during the 10-day period after repudiation was effectively addressed." He added that the FDIC will either pay in full whatever interest is accrued at the end of the 10-day period or these payments will be made through self-help remedies.

Aside from addressing the above risks, according to Binz, another takeaway from the final Safe Harbor is for the benefit of the major credit card issuers. Under the final rule, revolving trusts and the obligations issued by these vehicles either during or after the transition period are grandfathered into the 2000 Safe Harbor for as long as the trust existed and had issued securities by Sept 27, which was the date the final Safe Harbor was adopted. "This means that most major credit issuers' trusts would not be subject to the final rule in order to receive triple-A ratings from S&P," Binz said.


Structural Remedies

After the Safe Harbor rules were finalized by the FDIC, Moody's Investors Service released a report that said these were "safe enough" for securitization transactions.

According to Moody's, the proposed rule had conditions that would have been hard or even impossible to satisfy thus making it unclear whether the Safe Harbor could apply when a bank fails. By contrast, the rating agency said that the final rule relies on preconditions that are determinable at a deal's closing, instead of conditions that are ongoing and subjective throughout the transaction's life.

"We know what risks there are, and as long as bank sponsors can structure to cover them, then it's safe enough," said Sally Acevedo, vice president at Moody's and author of the above report.

An example of this is the missed interest payment risk that arises from the FDIC's statutory power to repudiate contracts of an failed bank, where the FDIC doesn't have to pay interest that accrues during the maximum 10 business days allowed between its repudiation notice and its repudiation payment.

This remains true in most cases even if the Safe Harbor conditions are satisfied. There are exemptions. For instance, the Safe Harbor safeguards certain master trusts, such as qualifying credit card master trusts, from this risk.

Acevedo said that they are waiting to hear definitely from the FDIC whether the missed interest payment risk could be covered by using either a derivative or funds from the reserve account, or some other mechanism. "This could basically be credit neutral as long as compensating structural features are available and employed," she said


Other Questions on Final Rule

Despite clarifying some of the provisions, market participants still have lingering uncertainties around the FDIC's finalized Safe Harbor for securitizations.

Edward Gainor, a partner at Bingham McCutchen, said that there are still many questions around risk retention. "Other than the FDIC, there is no other applicable rule yet in terms of risk retention, which puts banks at a disadvantage," Gainor said.

He explained that under the FDIC's rule, a party is compelled without exception to retain risk exposure that cannot be sold, traded or financed, either in the form of a 5% vertical slice on each tranche of the deal or a representative sample of the securitized pool. Under the Dodd-Frank Act, there are exceptions that are given for "qualified mortgages" and other high-quality assets.

Because of the economic advantages, "bank issuers would want to quickly switch out of the FDIC's rule into the Dodd-Frank Act," Gainor said.

Although there is an auto-conform provision in the FDIC rule whereby the Dodd-Frank risk retention provisions will prevail over those currently in the FDIC rule, Gainor said that it remains unclear when the switch from the FDIC rule to Dodd-Frank Act can occur.

"So there will be, depending on the asset class, around a year and a half when banks are going to be under a different regime, and that's a big concern," he said.

Another frequent query that Gainor has been asked is whether it is possible that banks that believe they are in compliance with the Safe Harbor at the time of the deal's closing will no longer be compliant when a bank becomes insolvent under the final rule.

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